On high yield and high risk investing in EM and junk debt

Right now, everyone is talking about an emerging markets crisis due to the simultaneous turmoil in several emerging markets. I am not concerned about this being a full-blown crisis yet. At the same time, I do want to use this as a launchpad for a discussion about high yield and high risk investments, whether they be leveraged loans and junk bonds in the US, sovereign debt in Greece or investments in emerging markets. Some of these are investments doing well, others are not. And this points to the ‘crisis’ as not being merely about risk-off.

If you look back to one year ago – pre-tapering – what you see in terms of US fixed income is a picture of incredibly low sovereign yields and low but not extremely low corporate risk spreads. Emerging markets were doing well. The 10-year Treasury was trading at 1.981%. The AAA/BAA credit spread was 95 bps, and the JP Morgan Emerging Market debt spread 244 bps.

Today, the picture is very different on the fixed income scene. The 10-year Treasury is now trading at 2.79%, off highs over 3%. The AAA/BAA credit spread is even lower at 66 bps and the JP Morgan Emerging Market debt spread has gone up to 376 bps. US yields are way up as are emerging market yields but spreads to junk are down to incredibly low levels. This picture is not fundamentally about a risk-off trade where people are rotating out of riskier asset classes due to the rise in US interest rates. Otherwise junk would be selling off – and its not. Instead, we should see what is happening in EM as something fundamentally about EM and not about US monetary policy.

Yesterday, I said the EM crisis has three causes: the bear market in commodities, macro imbalances and political risk in specific economies, and perceived tightening in the US and the UK. In my view, the most important theme here is the bear market in commodities due to Chinese rebalancing. And as a result, the most vulnerable countries are being hit. The tightening in the US and the UK only adds fuel to the fire.

Look at two crisis flash points, Turkey and Argentina. Yesterday, we saw Turkey raise rates fairly dramatically. And the effect on the currency was instantaneous. The currency is up and confidence in Turkey has been partially restored.While the real economy may suffer due to the rise in rates, the move in Turkey has lessened the crisis in Turkey.

On the other hand, Argentina tried to stem the tide of crisis by devaluing its currency to more accurately reflect the declining external value of the peso. But the move has backfired, with Argentina’s US-dollar sovereign bonds declining on the news. Russia may be able to depreciate its currency without problems because it is a net exporter. But Argentina’s trade balance has been deteriorating and that means a decline in the value of the peso will add domestic inflation. And this effect overwhelms the positives of Argentina recouping reserves with which to pay its dollar-based sovereign debt. I think out of control hyperinflation is a real risk in Argentina.

Argentina is taking it on the chin not because speculators hate the country for flouting the powers that be in the US and other developed countries as Cristina Fernandez claims. Rather, Argentina represents a poorer risk return based on the economic policies it is pursuing. It’s as simple as that.

In the US, the high yield situation is in the blow-off stage, meaning we are deep into excess credit risk. The Office of the Comptroller of the Currency has warned that junk deals are becoming too risky:

The Office of the Comptroller of the Currency has already told banks to avoid some of the riskiest junk loans to companies, but is alarmed that banks may still do such deals by sharing some of the risk with asset managers.

“We do not see any benefit to banks working with alternative asset managers or shadow banks to skirt the regulation and continue to have weak deals flooding markets,” said Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the OCC, in a statement in response to questions from Reuters.

Among the investors in alternative asset managers are pension funds that have funding issues of their own, he said.

“Transferring future losses from banks to pension funds does not aid long-term financial stability for the U.S. economy,” he added.

High yield and leveraged loan deals were issued in record amounts last year and the terms of those deals are increasingly lax. We see a move to payment-in-kind debt terms and light covenant restrictions as well as an increase in deal leverage. Average debt to EBITDA on leveraged loans in 2013 was 6.21, the highest since 2007 when the last crisis broke.

Why is this happening? It is happening because there is demand for higher yielding paper. Insurance companies have policies to pay and the nominal returns they are receiving do not cover those payouts. Look at what is happening in Japan, the land of low returns:

Axa runs a tight ship in Tokyo. The Japanese arm of the giant French company tries to make so much money from selling insurance and other services that it doesn’t have to worry about margins on its Y5tn ($48bn) portfolio of investments, more than half in government bonds.

Even so, it plans to eke out more income by buying more US corporate bonds and private-equity loans this year, to offset the yield-crushing effects of aggressive monetary easing.

Since Haruhiko Kuroda, Bank of Japan governor, pledged last April to buy enough bonds to double the monetary base by the end of 2014, interest rates have ground steadily lower, after a couple of hiccups. The 10-year government bond currently offers the only sub-1 per cent yield across the developed world, at just 0.63 per cent.

“If low yields continue, it will have an impact on us”, says Mitsugi Sumiya, Axa Life’s chief financial officer, noting that many other Japanese insurers are already under water, paying out more on policies than they earn from the assets underlying them. “We are looking to take more credit risk in the US and Europe.”

That would fit the government’s vision. As part of its war on deflation, it wants to steer bond-heavy investors into racier assets such as stocks and property, while keeping downward pressure on the yen by pushing them into higher-yielding assets overseas.

This process – “portfolio rebalancing” – is one of the ways in which Japan is supposed to get more comfortable with the idea of nominal growth and inflation, after two decades in which it has seen precious little of either.

This is exactly the same process we see in the US. Investors are starved for yield and they have begun reaching for yield as a result. That is why the AAA/BAA credit spread is 66 bps. That is why leveraged loan deals are getting done at average debt to EBITDA of 6.21 times. That is why covenants are less restrictive. And that is why we see all these payment-in-kind notes in junk deals. The Fed has kept rates so low for so long that it has shifted portfolio preferences to junkier, longer-lived investments – ones I believe will blow up when the next downturn hits. Apparently, policy makers believe this is the only way out of the mess we created with the housing bubble. But we will soon see that the Fed has created just as many problems as it has solved. When the cycle turns down, the writedowns will be large.

For now though, EM is the only high yield and high risk market selling off. Junk in the US is doing well and peripheral sovereign debt is doing well too. I expect this dynamic to continue until the real economy turns down in the US and Europe. In EM, the best play is corporate debt because big corporate debtors are not excessively leveraged to their domestic economies and that means the carnage in emerging markets affects them less. Equities are down over 20% from the 2011 peak though. So I see corporate debt as the EM safe haven, more so than sovereign debt or equities.

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