This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Fraser Lundie, co-head of Credit at Hermes Fund Managers explains why emerging market high yield now warrants special attention.
It wasn’t long ago that global high-yield credit investors had essentially two choices in terms of regional preference: North America and Europe. But with the growth of emerging market corporate debt over the past decade, and its increasing contribution to performance dispersion within major benchmarks, emerging market high yield is now a sector that warrants special attention.
It makes sense to be adding emerging market risk
This has become even more obvious after the recent underperformance of emerging market risk assets: while the current political and economic outlooks for emerging market countries remain murky at best, valuations are beginning to look cheap relative to developed market high yield. So is it time to go overweight emerging markets?
In 2008 emerging market bonds claimed a notional share of only 8.5% in the Merrill Lynch Global High Yield index. Since then the notional amount of emerging market bonds in the index has grown exponentially to comprise 14.1%, or $295 billion, of the index. However, this only tells part of the story. A better measure of index weight is to adjust the notional for the bonds’ beta, a metric called duration-times-spread (DTS).
DTS recognises that bonds with a longer duration and/ or higher spread have a higher beta and thus will have an outsized impact on the total return of the index relative to bonds with a lower DTS. Using this metric, emerging market’s share of the index has grown from 8.9% in 2008 to 22.5% today. This compares with 55.4% for North America and 21.5% for Western Indeed, emerging markets now provide a greater index contribution than Europe adjusted for duration and spread – a fact that is perhaps not fully appreciated by investors.
While bearish headlines regarding the outlook for emerging market economies picked up towards the end of 2013, their bond markets began to show signs of weakness even before the US Federal Reserve first hinted at tapering, or reducing its asset-purchasing program, in May 2013. Since March last year, emerging market high yield has underperformed developed market high yield by a substantial margin.
On an absolute basis, emerging market spreads are nearly 70 basis points wider over the past year while developed market spreads are 90 basis points tighter. Over the past year emerging market high yield has lost 0.18% compared to a positive 8.41% return from developed market high yield.
What’s behind this underperformance? The most obvious and likely explanation is capital flows driving up risk premiums. When, in 2013, the market sensed that an end to quantitative easing was a medium-term event, the four-year reach-for-yield trade ended. Capital flows to higher yielding emerging market bond markets abruptly reversed.
Emerging Market Credit: Getting Cheaper
With the Fed seemingly sticking to its tapering schedule, it’s not unreasonable to assume that emerging markets will continue to underperform developed markets over the short to medium term. While absolute spread levels of 686 basis points don’t suggest emerging markets look exceptionally cheap just yet relative to developed markets, emerging market valuations are approaching extreme levels. This is clear when viewing the ratio of emerging market spreads to developed market spreads, which normalises for market beta.
Clearly, part of this valuation anomaly is driven by the fact developed market spreads are near record tights. Importantly, this means that if the situation in emerging market countries normalises, it will be highly unlikely for developed markets to continue to outperform emerging markets. Whenever valuation points reach such extreme levels we believe benchmark-oriented investors need to be cognisant that the risk of being underweight emerging market credit increases for every additional basis point of underperformance. With this in mind we believe it makes sense to be adding emerging market risk on further underperformance.
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