The most successful investment strategy that we've seen in the fixed income space in the past few years has been buying and holding till maturity. With emerging markets, junk or investment grade corporate bonds, regardless of what investors were holding, the highest probability was that asset prices would rise and defaults would remain a remote possibility. Although we have witnessed episodes of volatility such as the fall in oil prices in 2014, and more recently the imposition of sanctions on Russia, we can safely say that if a portfolio was well diversified, an active management of assets was unnecessary.
Now that things are changing fast with a more hawkish Fed, a rally by the USD and increasing volatility in the equity space, the buying-to-hold strategy is quickly becoming outdated and could cost investors a lot of money, especially if they do not clearly consider the underlying risks embedded in their portfolios.
As we explained in our Q2 Outlook, there are more and more signs of stress within the fixed income space and in several articles we also discussed the fact that US Treasuries are heading only one direction: down. It is therefore time to take a different approach to investing and to ask ourselves whether the areas where we once saw limitless possibilities, such as the EM sovereigns, will actually be able to continue to deliver.
In the past decade investors have been attracted to EM sovereigns because of the much higher yields that these countries offered. Very few ventured to invest in EM corporates as sovereigns have generally regarded to be safer than corporate bonds for the simple reason it is rare for a country to decide to default on its own debt knowing that it would be challenging to raise capital in the future. Apart from some well-known default cases such as Argentina, Venezuela and Zimbabwe, other developed as well as emerging countries have normally maintained their obligations concerning coupon and notional repayment.
Today, however, there are increasing signals suggesting that things may be changing especially for weaker economies. In the past few years, weaker economies have issued large volumes of long-term sovereign bonds in USD at favourable interest rates. For example, last September, Ukraine issued $3bn sovereign bonds with 2032 maturity at 7.375%. Similarly, at the beginning of the year, Ecuador placed $3bn of sovereign bonds with 2028 maturity at a yield of 7.875%.
Now that investors are realiding that the overall economic conditions of these countries is deteriorating due to several factors such as high debt burdens and a strong US dollar, the value of these sovereigns is falling quickly, with Ecuador 2028 now pricing in the mid-80s (10.15% yield vs 7.875% at issuance) and Ukraine quoted in the low-90s, resulting in a yield approximately a point higher since issuance. Even South Africa, that has been enjoying positive market sentiment following the election of the new president Cyril Ramaphosa has recently suffered of a major sell-off.
Things are also going badly even for countries for which investors had high hopes. One of these is for sure Argentina, which last June successfully placed USD 2.75bn of 100-year bonds at an effective yield of 8%, a modest interest for a country that in the past 35 years has defaulted five times, with the default of 2001 being the largest sovereign default in history. Now, this bond is trading at five points discount from issuance, but there is risk it will further decrease in value should a full-blown currency crisis occur.
Once again, investors have shown themselves to be overly positive, only basing their actions on news concerning the political agenda outlined by president Mauricio Macri, who since December 2015 has promoted policies that would stop currency controls, trade restrictions, and limit government spending, quite unlike his predecessor, Cristina de Kirchner.
At this point we cannot have confidence even in those countries which economies have recently improved thanks to their proximity to and dependence on stronger regions. One of these regions is the central eastern European region. The reason to be suspicious is the fact that although its sovereigns are sometimes better rated and trade tighter than other European sovereigns, they still face challenges typical of emerging economies, and on the top of this they are far less liquid than bonds issued by the G7. At this point, although the political situation is unstable, sovereigns of the periphery seems more appealing.
Considering the above, and without forgetting that most of the time when sovereigns default is normally by choice and not because the country doesn’t have money to pay back its debt, it becomes natural to shift away from EM sovereigns and look for solid opportunities which can enable us to cherry pick and limit risks, while still gaining interesting yields. US high grade debt has recently gained more and more visibility in this respect as valuations have softened up since January.
Moody’s fourth quarter default rate in USD corporate debt has fallen to 3.3%, and the rating agency is forecasting that in a year's time the default rate in this space will halve. Although this figure gives just an indication, we cannot forget that although the cost of funding is rising for the majority of companies worldwide, most them have been able to borrow at convenient rates until now, and while interest rates rise slowly, corporates still have the time to position themselves in an environment of rising interest rates.
The US high grade space becomes particularly interesting when one realises that spreads have been widening at a faster pace than junk bonds since the beginning of the year (Figure1 below).