Thursday, February 08, 2007

Chasing EMBI: the hunt for high yield

Not too long ago, in the comments section of our site, one of our dear readers suggested a discussion topic for an upcoming post. The proposed idea: that, "the high-yield market is really the new investment grade market".

Well baby, you asked for it; you got it. We aim to please, after all. What follows are a few bits of insight and analysis into this trend towards high-risk, high-yield investment in the corporate junk-bond market and the world of emerging market debt.

First off, a word about the current investment climate. The main idea behind this post topic is that investment yields and perceptions of risk are low, pretty much across the globe wherever you look. As we see it, real returns on US government bonds are basically flat to negative if you factor in the expenses of taxes and the current rate of inflation (when judged more honestly than by the government's measures).

Investors have had to look farther afield for higher returns in recent years. This applies to alpha-seeking hedge fund managers as well as retail investors and retirees. We've seen more people shrugging off risk in the current environment, with individual investors seeking returns in junk-bond funds and emerging market bonds, while the professional investors juice their performance with carry-trades, leverage and a trip to the frontier markets.

For those still operating on the notion that compressed yields and risk spreads have arised out of a "savings glut", may we instead point you towards the root cause of this supposed phenomenon. Namely, the expansion of money and credit on a wildly unprecedented, global scale. In other words, the "savings glut" might be more accurately characterized as a "liquidity glut".

This mass of global liquidity sloshing about the globe is a large part of the reason why so much money and attention has been directed towards these high risk arenas. Competition in the search for yield is intense. As Financial Times columnist John Dizard recently put it:

The rapid tightening in risk spreads over the past few weeks has left portfolio managers in a bad way. There just isn’t much discernable value out there. Now they’re picking through the rubbish piles of junk bonds looking for scraps of yield they can take back to their hungry clients. If their situation gets any more pathetic, they’ll have to recruit Bono to raise their year-end bonuses.

FT reporter Joanna Chung echoes these sentiments in her more recent report, "EM bond spreads at record lows". As her article details, spreads of emerging market bonds (as measured by the JP Morgan EMBI+ index) continue to narrow against US treasuries.

An excerpt from that piece:

Risk premiums on emerging market bonds on Tuesday were close to record lows as hopes of a credit rating upgrade for Brazil spurred another round of buying.

As bond prices rose, the risk premium on emerging market bonds, as measured by JPMorgan’s EMBI+ index, a market barometer, touched an intraday low of just 164 basis points over US Treasuries during trading. The lowest close for the index – 165bp over US Treasuries – was reached on Friday.

The article goes on to report that an eventual, hoped-for upgrade of Brazil's credit rating is seen as "an overall positive for emerging markets", and that despite recent jitters, demand for emerging market debt remains strong. If anything, risk spreads are expected to narrow further.

...risk premiums are expected to continue heading lower this year. Yield-hungry investors are pouring money into emerging market assets at a time when the supply of sovereign paper is on the decline. Financially stronger governments are issuing less debt while buying back old bonds. And investors are scooping up bonds of emerging market companies and banks instead, among the fastest growing segments in emerging markets.

The trend of increased complacency towards risk in the hunt for yield did not begin strictly with the junk bond and emerging-nation debt markets. In fact, we can go back to 2005 to see evidence of this behavior among investors bidding for the newly reintroduced 50 year bonds that were issued by leading Western governments.

Are purchasers of ultra-long maturity bonds being compensated with extra yield for investing longer and taking the inflation risk? Not quite, it seems. As the Times article pointed out, due to high demand for long-term bonds, the UK yield curve is currently inverted and offers less reward for investing longer.[4]

Despite this, pension funds seeking to avoid shortfalls and appease regulators are not the only buyers in the market. Hedge funds and insurers were said to account for a notable chunk of demand in the French treasury’s 50-year auction. [5] Although the French bonds were “priced to yield just 4.21 percent – only three basis points above the yield on France’s 30-year debt”, the issuance was oversubscribed. [6]

The situation is not so different for corporate issues as one skeptical investment manager has noted. “That the BBB-rated Telecom Italia was able to raise almost 600 million [pounds] for 50 years - and at a coupon of just 5.25% - illustrates how little the market is demanding for risk at present”. [7]

Turning back to the issue of high demand for emerging market and junk bonds, Martin Hutchinson, writing for the Prudent Bear website, makes the following points of caution regarding the current state of the high-yield and emerging debt markets:

This is the ugly secret about B rated bonds: if monetary conditions remain easy, then increased investor appetite allows potential defaulters to refinance instead of defaulting, which in turn keeps default rates low and increases investor appetite. This has particularly been the case in the last few years, when hedge funds have been able to raise almost unlimited capital from foolish institutional investors, leverage themselves to the hilt, possibly in yen, from foolish banks and then invest the gigantic proceeds in junk bonds, for their modest additional yield above U.S. Treasuries.

Provided the junk bond market doesn’t crash, so refinancing of all but the worst rubbish is still readily available, hedge funds can in any given year achieve with almost complete certainty a satisfactory return, at least 20% of which will flow to the hedge fund managers personally. Thus the normal corrective mechanism of rising default rates ceases to work, and the market spirals towards bond-market nirvana. Essentially the safety valve on the engine of speculative financing has been jammed shut.

This is even more the case internationally. The only thing that ever causes countries to default is a refusal by the bond markets to finance their deficits. Since in an easy money period, with generally declining spreads, the bond market is open to all borrowers, no defaults ever occur. That’s why there has not been a sovereign default since Argentina went in December 2001. The IMF and World Bank and the Bush administration can hold conference after conference congratulating themselves on their superb management of the international financial system, which has caused the world to be free from “crises” for half a decade.

In reality the lack of crises is nothing whatever to do with good management, but is simply a function of excess liquidity.

Thanks to John Rubino at for recently highlighting the above quoted passage.

Given all this knowledge, we have to ask the question: what might happen to throw a wrench in the works and send these trends into reverse? In other words, what will happen to halt the pursuit of returns at a time when most investors are (arguably) oblivious to risk?

Could it be the unexpected arrival of a credit crunch that will have investors bailing out of high risk investments and running for cover? As Barry Ritholtz pointed out on his Big Picture blog, Merrill Lynch has offered just such a forecast.

Even if, as Merrill's report suggests, European and Asian central banks are expected to tighten monetary conditions through higher interest rates, this may not result in truly tight conditions if money and credit continue to be issued through other channels. However, it could be enough to scare many investors into thinking that the central banks will have succeeded in their task, especially if inflation rates remain underreported across the globe. Be sure to look for signposts on the road ahead.

We'll leave it there for now. If anyone is interested in learning more about these trends, please feel free to review the source articles mentioned here, and if you have some insights to share, provide us with your feedback.