Summary: The desperate search for yield over the past few months has led bond investors to seek relative value in the EM and corporate junk spaces. But while the yields available are attractive, is the risk really worth it?
Buying a bond is a little bit like shopping for clothes. You want to find the perfect fit: something not too short, yet not too long; something daring but yet not too risqué, basically something that can return the result that you have been expecting when buying that particular product.
Investors have been on a frantic shopping expedition in bond and equity markets so far this year, causing valuations to go up and returns to fall considerably. The issue that we now face is that the market has been shopping for quality and junk, and it is very hard to understand why investors have been adventuring within the weakest pockets of the economy, especially amid talk of a global slowdown and a global policy panic.
The rally we have experienced thus far can only be ascribed to dovish central bank policies. Investors are betting that they will be successful in supporting the economy and market valuations, hence we came from a dreadful sell-off during the fourth quarter of last year to a whatever-you-can-eat frenzy that has pushed risky assets higher. The most worrying news I’ve heard in the past few days is that Bitcoin jumped 21.5%, just a after a market-wide rally caused by better-than-expected PMI numbers in China. This clearly shows that instead of buying on fundamentals, markets are actually buying on sentiment.
This forces us to take a reality check, especially in the corporate space. Are corporate bonds in the junk space and in emerging markets really worth our money?
As we can see from the chart above, junk bond spreads have been tightening faster than those of the EMs, suggesting that what investors have been picking up all this time is mainly junk! Indeed, the EM Corporate Average OAS Index also includes Investment grade corporate bonds, thus it is normal that spread in the HY Corporate index is higher than that of the EMs, although during exceptional periods such as during the EM currency crisis we saw last summer, spreads in the EM corporate space rose against those of the HY corporate space, expressing a higher risk of defaults.
Yet are yields in these two categories really compensating investors for their risk? The only way to find this out is by doing a comparative analysis between what can be found in the HY space and EM space vs IG names available in the developed world.
I have been looking at corporate names within these spaces with maturities of up to 10 years, and this search led to striking results.
On average it can be said that yes, the emerging markets and the junk corporate bond space provides a pick up over the average IG yield of approximately 200bps. This obviously cannot be ignored as the gains are substantial. However, when I proceed to screen for higher yielding names in the investment grade space I can still find a bunch of corporate bonds that match the yields of bonds belonging to the two other categories.
For example, I can see that the subordinated bond of Russian Sberbank pays a coupon of 5.25% and with a maturity of May 2023 and rated BB+ by Fitch (XS0935311240) is offering a yield of nearly 4.95%. At the same time Unicredit is offering a senior non-preferred bond with coupon 6.572% with maturity January 2022 rated BBB by Fitch (XS1935310166) that is offering a yield of 4.6%.
But as profitable as Sberbank is, the decision to put your money to work in a subordinated issue of a bank that might be hit by the next round of sanctions that the US decides to impose on Russia for just 30bps pickup over an investment grade European bank bond issue doesn’t make much sense to me.
To give you another example, Pemex is offering 4.7% in yield for its senior unsecured bonds with maturity January 2023 and a coupon of 3.5% and a rating of BBB- (US71654QBG64), but Jeffries is offering just 50bps less in yield for senior unsecured bonds with a coupon of 5.5% and maturity October 2023 with rating BBB from Fitch (US527288BE32).
Are investors perhaps ignoring the fact that Pemex is a highly unprofitable company, and now that there is a new populist president in place, political risk has risen considerably, and things can quickly change for the state owned oil company? It’s very difficult to say. However, what can clearly be said is that this desperate chase for yield has pushed investors further and further from their usual environments, towards riskier assets without appreciating the political, economic and systemic risk that is attached to them.
MMT will not be enough to support an overleveraged system that has becoming inefficient, especially when data show that things are not as they were before. This is why it is to be recommended that investors are selective with the risk they take on risk and chose bonds from companies with the ability to pay their coupons from their cash flows. Although this might be seen as a conservative view, we believe that investors are still able to get solid returns while the economy turns.