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At the end of last year I thought there was still just a bit more juice to be had out of emerging market bonds. The EMBI index of external bonds had a stripped spread over US Treasuries of 245 basis points, and it seemed possible we could have a modestly good performance over the remainder of the year.
That turned out better than I would have thought, with the EMBI global down to a historically tight spread of 179 off the Treasury curve by last week. My nerve has given out, though. It is time to get out of the generic EM bond basket. The one-decision bet on the index just doesn’t look attractive any more. “Emerging markets” was always something of a marketing concept, in any event – one crafted to soothe the easily spooked middle American mutual fund buyer and insurance bureaucrat. This was always a more divergent group than the brokers, sorry, investment advisors tried to lead you to believe.
But the marketing concept took on a life of its own. You, collectively, have been encouraged to buy more EM bonds in one form or another because you, collectively, have been buying more EM bonds. The “flows”, or the “technicals”, of money desperately searching for a home have driven the various EM indices as much, in some cases, as the improving fundamentals.
The rate of increase of those flows has been slowing. Cycles being what they are, particularly in a rising rate environment, the increases will turn into decreases, if not actual repatriations. So it is time to abandon the generic EM strategy and plot out a more considered approach. Sell the EM indices or the funds with managers who still buy that story. “The spread compression is mostly done,” as Stephen Gilmore, an executive director of AIG Financial Products in London, says.
But what, you ask, to do? Even with the worldwide tightening in monetary conditions, rates in the (currently) rich countries are not high enough to support most people’s lifestyles, or their fiduciaries’ actuarial assumptions. Buying developed world junk bonds at the end of an economic cycle has not, historically, proven to be a good idea for anyone other than the bankruptcy bar. So it’s back to EM.
The trick, I believe, is to go for a combination of short-term positions in high-yielding EM currencies and a set of external (dollar), longer duration (say 10-year) bonds issued by lower risk countries. You pay for that with the proceeds from selling the EMBI Global index, or a similar fund, with its six and a half year duration.
“That’s something like what we are doing,” says Curtis Mewbourne, who manages part of Pimco’s $30bn in EM bonds. “We don’t need to be in all the boats. Among EM managers, we are among the most comfortable in moving out of some countries and into others.” In its separate account business, where Pimco manages asset allocations as well as portfolios for corporate clients, Pimco has moved to a mix of 70 per cent external EM bonds and 30 per cent local currency bonds. “That’s not your barbell,” Mr Mewbourne says, referring to the strategy I outlined above, “but it is closer to that than we were.”
For the external bond part of the portfolio, I like Mexico, Russia, South Africa and Iraq. You can pick your weighting but I’d just buy equal amounts.
Mexico has been selling off lately, with rich Mexicans taking the lead. They do have a problematic election coming up but as I laid out early in April the country has reserves about equal to its external debt. The locals are too worried. To get a little more income for effectively the same risk, buy the Pemex 10-year paper at 110 over the Treasury curve. Do the same in Russia by buying Gazprom paper at 120 off Treasuries.
South Africa is perhaps the most expensive, at only 90 basis points off Treasuries, but you diversify your commodity exposure, and its monetary and fiscal policy has been good.
Now, Iraq. Yes, political risk. But think about it. You’re being paid 433 basis points off Treasuries, or a current yield of 8.43 per cent and a yield to maturity of 9.12 per cent. Even so, the renegotiated debt service for Iraq is minuscule and easily covered by oil revenues. Forget the talk about breaking up the country. It may have a weak central government but it will have one. A dismembered Iraq would raise too many questions about the other countries in the region. Iran, Saudi Arabia, Turkey, and the US have their differences but they agree on that. And the civil war, which is what it is, is really a lot of small-scale engagements and murders. Figure on four or five more years of cruel sectarian war, then a settlement and a gradual building up of oil production.
In the meantime, Iraq’s dollar bonds are virtually the only country’s paper whose interest payments could cover corporate America’s pension actuarial assumptions. Does that tell you something about the safety of your retirement income?
There can be administrative issues for the individual investor wanting to park money in short-term EM instruments, due to restrictions on international flows in and out of the paper. But if you have a large account with a private banking group it can get you exposure to those currencies, possibly using offshore instruments such as non-deliverable forwards. I like 30-day positions in Brazil (15 per cent), Turkey (13-14 per cent), and Indonesia (13-14 per cent). That is a short but reasonably diversified list. With high yielders and diversification, I think you’re paid enough for the risk.
“This is a good time to take profits on the EMBI,” says Christian Stracke, an EM analyst with Creditsights, the independent research company. “There are technical flows that will support it until the end of May, such as buybacks and maturing issues. After that, the flows will fade. So it makes sense to play defensively.”
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