Chas Craig, BridgeTower Media Newswires
After the 2016 elections, investors probably became overly complacent about the prospects for trade protectionism that had been floated by the Trump campaign and the possibility that the U.S. Federal Reserve could hasten its monetary tightening if inflationary pressures built. Happening together, these two developments likely lead to a strengthening dollar.
Historically, abrupt dollar strengthening often leads to capital outflows and currency devaluations in emerging markets that have marked the beginning of prior emerging market mini-crises. This scenario having come to fruition, emerging market bonds (EMB) have performed poorly of late, with the fallout in emerging markets being accentuated by the Crisis in Turkey.
Although roughly half of the EMB universe is rated investment grade, an EMB allocation should be viewed as a “risky asset” that is likely most closely comparable to the risk and return characteristics of U.S. high-yield bonds (HY), those bonds also referred to as junk bonds, which are rated below investment grade, in most U.S. based investors’ portfolios. Year to date, the ICE BofAML U.S. High Yield Index has returned 2.2 percent, compared to -3.4 percent for the Bloomberg Barclays EM USD Aggregate Index. With this recent underperformance, EMB has reached a yield relative to HY that is only rivaled in its attractiveness over the past decade by the late-2013 to mid-2014 experience. Please see the graph below, data courtesy of Bloomberg, which shows the extra yield (y-axis shown in percentage points) investors receive for owning HY as opposed to EMB denominated in U.S. dollars over the last 10 years.
For the full period, the average spread was 2.0 percent and the median was 1.6 percent. Per usual, low relative valuations (When the spread is high, HY is attractive, and when it is low, EMB is attractive.) in this series were associated with superior one-year forward returns. To this point, using the most extreme readings, after hitting 10.8 percent in December 2008 during the Financial Crisis, HY outperformed EMB by 29.7 percent over the next year. Similarly, although of a much lesser magnitude, after reaching 0.0 percent in March 2014, EMB outperformed HY by 2.0 percent the following year. The current spread reading is 0.35 percent. As previously mentioned, since 2008 the only other time the spread was this low was during the late-2013 to mid-2014 period. The average one-year forward outperformance of EMB over HY for the 49 trading days that saw a reading of 0.30 percent to 0.40 percent during that time was 1.7 percent. Therefore, while there are fundamental challenges in the emerging world, given low valuations for EMB relative to HY, it is likely a good time to evaluate one’s allocation between these two risky bond classes.
As discussed recently in this space (see: Junk Bonds – Tax Reform and Valuation), HY appears quite unattractive viewed through the most commonly cited valuation metric for the space, the extra yield investors receive over comparable maturity U.S. Treasury bonds. Certainly, there are reasons for credit spreads to be tighter than normal currently. Chief among them, corporate profitability has been very solid of late with the overall state of the domestic economy providing a nice tailwind. However, it is the starting valuation level that is most often the largest determinant of prospective returns, not the then prevailing fundamental backdrop. Further, since fundamentals and valuation usually (not always) revert to long-term means, the most successful investments are typically made during times of depressed fundamentals and valuations.
However, while EMB may offer good relative value to HY just now, on an absolute, stand-alone basis, EMB is probably best described as being somewhat attractive. To become more comfortable with adding exposure to a risky asset like EMB via the reduction of a safer asset (i.e. high-quality bonds) instead of another, pricier risky asset (i.e. HY), investors may want to wait for the type of panic and capitulation that has historically been associated with good buying opportunities.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
