While emerging market bonds have notably underperformed in the year-to-date period, Fund Manager Claudia Calich believes the longer-term fundamental case for the asset class remains intact. The outlook for broad-based global economic growth is still in place, for example, which should help fiscal improvements and deleveraging in emerging countries. In this Bond Vigilantes video, Claudia also no…Watch the video
Emerging markets debt posted strong returns in 2017, driven by the stabilisation of fundamentals, ongoing global and EM economic recovery, a small rebound in commodity prices and a geopolitical environment in which the usual suspects (Trump, North Korea, China) have behaved in a more benign fashion thus far. One had to struggle to find an asset that produced negative returns and the only two th…Read the article
Let’s be honest, 2017 won’t go down in history as the most exciting year for investment grade (IG) credit markets. IG credit spreads have moved more or less in one direction only: lower and lower. Still, there are valuable lessons to be learnt. Here are our key takeaways.
Positive mood swing in Europe drove EUR IG outperformance vs USD IG.
Back in early 2017 the logic was as follows: After the…Read the article
Another month has drawn to an end, which presents a good opportunity to take stock and review recent events and Bloomberg’s surprise monitors – true to their name – have provided some unexpected results in August.Read the article
Earlier this year we interviewed both Robert Gordon (here) and Martin Ford (here) about their books examining the impact of technology on the modern economy. In the latest of our author interviews I talked to the Economist’s senior editor and economics columnist Ryan Avent about his new book, “The Wealth of Humans”, that develops this same theme. In particular he looks at how we will be able …Read the article
Watching the news flow on the global economy is dispiriting. Ask an economist what springs to mind when they hear the word “Europe”. They will probably reply with thoughts about negative interest rates, deflation and debt concerns. It isn’t much better when you bring up the economic outlook for the US (“the upcoming election is a concern”), Japan (“the BoJ is at the limits of monetary policy”),…Read the article
It has been quite an eventful year for emerging markets. The fall in oil and commodity prices, the prospect of higher interest rates in the US, the corruption scandal in Brazil and of course the growth slowdown in China have all contributed to increased uncertainty for the asset class. Naturally this uncertainty has impacted performance, weighing down on returns of both hard and local currency …Read the article
High Yield Floating Rate Bonds
With many of the conditions for the economy to normalise now met, the point at which interest rates also begin to normalise is getting closer.
Bank of England Governor Mark Carney, Liverpool, 9 September 2014
… with the economy getting closer to our objectives, the FOMC’s emphasis is naturally shifting to …. the question of under what conditions we should begin dialling back our extraordinary accommodation.
Federal Reserve Chair Janet Yellen, Jackson Hole, 22 August 2014
We are entering a new era for interest rates in the developed world. The extended period of ever looser monetary policy is starting to draw to a close. In the wake of the tapering of quantitative easing (QE) from the Federal Reserve (Fed), investors now expect to see the first interest rate hikes in many years, initially in the UK and shortly afterwards in the US (see figure 1). The principal focus of the debate is over the questions of “when?” and “how fast?” interest rates should rise, not “if?” For bond investors in particular, this transition has thrown up a lot of difficult questions. Having benefited greatly from falling yields and tightening credit spreads, the move to a more hawkish cycle will create many more headwinds and challenges when it comes to delivering returns for many fixed income asset classes.
Consequently, any product or instrument that can help investors navigate this environment has rightly been receiving a lot of interest and attention. In the latest in our series of the Panoramic Outlook, we will focus on one such instrument, the high yield floating rate bond. In recent years, this instrument has gained popularity with many issuers and the market has grown to a total US$44 billion.
A high yield floating rate note (FRN) has two key defining features: (1) a floating rate coupon that is automatically adjusted in line with changes in interest rates; (2) a relatively high credit spread that reflects the additional credit risk of a non-investment grade issuer.
It is the combination of these two features which not only enables investors to receive an attractive income stream now, but also allows them to benefit from higher coupons should interest rates increase with no associated loss to capital. This last element, the lack of a hit to capital in a rising interest rate environment, is the key difference to the traditional universe of fixed coupon bonds which suffer from price declines as yields move up.
In this issue, we will take an in-depth look at the characteristics and make-up of the high yield floating rate bond market. We will also consider the key drivers of returns, as well as some of the risks and how these can be managed.
High yield floating rate bonds 101
The key features of high yield floating rate bonds can be summarised as follows:
- It is a bond issued by a company that has a below-investment grade credit rating
- The coupon, usually paid quarterly, is made up of:
- a variable component which is adjusted in line with a money market reference rate, typically every three months (throughout this article we will refer to this measure as ‘3-month Libor’)
- a credit spread, which is fixed for the life of the bond and reflects the additional credit risk of lending to a company
- The bond has a fixed maturity (typically 5-7 years at the time of issue)
- The bond is a publicly traded instrument that can be bought and sold like any other corporate or high yield bond
- As an example, suppose that a 5-year bond is issued with a coupon of 3-month Libor + 450 basis points (bps). For the first year, 3-month Libor is 50bps, so the coupon is 500bps (or 5%) over that period. In the second year, 3-month Libor rises to 75bps, so the coupon increases to 75+450 = 525bps, or 5.25%, during that period.
|Table 1: High yield floating rate market compared with other fixed coupon bond markets|
|Index||Global High Yield Floating Rate||Global Government Bond||Global Corporate||Global High Yield|
|Average maturity (years)||4.5||8.9||8.7||6.1|
|Effective duration (years)||0.03||7.2||6.2||4.2|
|Spread duration (years)||2.1||6.9||6.1||4.1|
|Face value (US$ billion)||44||23,081||7,964||2,057|
|Yield to maturity (%)||4.5||1.3||2.7||6.1|
|Spread (vs government bonds, bps)||400||14||110||435|
|Source: M&G, BofA Merrill Lynch, 5 August 2014.|
Table 1 highlights some of the characteristics of the high yield floating rate market and compares it with the more traditional government, corporate and high yield fixed coupon bond markets using data from Bank of America Merrill Lynch’s fixed income indices.
In terms of credit risk (measured by the composite rating) and credit spread (the yield premium above government bonds that compensates investors for the higher risk of default), the high yield floating rate market is very similar to the traditional high yield market. This is to be expected as there is a great deal of commonality between the two in terms of underlying issuers.
The big difference is revealed when we start to look at the effective duration numbers. Effective duration measures the sensitivity of bond prices to changes in yields. A duration of 4.2 years means that for every 1% increase in yields, there will be an approximately 4.2% loss of capital. The effective duration of the High Yield Floating Rate Index is very close to zero (due to the regular re-setting of coupons, cashflows are only fixed for a very short time). This means that if, all other things being equal, there is a broader sell-off in the government bond markets and all fixed income yields need to adjust upwards, the capital loss would be close to zero.
This limited exposure to moves in the broader yields means that the high yield floating rate market tends to be much less sensitive to any wider interest rate inspired volatility in the market. Indeed, during the so-called ‘taper tantrum’ of 2013 when former Fed Chairman Ben Bernanke first introduced the idea that QE would begin to be phased out, the high yield floating rate market was much more resilient in terms of price impact than the other major bond markets as investors adjusted to the concept of tighter monetary policy (see figure 2).
We can also see how this might play out at an individual bond level. In July 2014 Iceland Ltd, a UK supermarket, issued both a £350 million FRN, paying Libor + 425bps maturing in 2020, and a £400 million 6.25% bond maturing in 2021. Both bonds are pari passu senior secured liabilities that are issued by the same company. In other words, the credit risk in both instruments is effectively identical. However, the interest rate risk exposure is very different. Take the following hypothetical scenario:
- Both bonds start the year priced at 100% of par
- For the first six months of the year, 3-month Libor is at 0.56%
- Halfway through the year, the Bank of England unexpectedly increases the bank rate by 50bps, which pushes 3-month Libor to 1.06% and re-prices gilt yields up by the same amount across the curve
- Credit spreads remain the same throughout the year
While this is an unlikely scenario, it does help to simplify the maths. The interest rate duration of the 6.25% 2021 bond is close to 5.5 years, so a 50bps move in underlying yields means a capital hit of around 2.7%. This is offset by 6.25% of income from the coupon, so the total return over the course of a year is 3.6%.
|Iceland bond||Fixed 6.25% 2021||FRN 2020 (L+425)|
|Change to price (%)||-2.68||0.00|
|Coupon return (%)||6.25||5.06|
|Total return (%)||3.57||5.06|
In contrast, the FRN has minimal interest rate duration, so does not suffer a capital loss. Indeed, as Libor goes up by 50bps for the second half of the year, the coupon rises from an annualised 4.81% to 5.31% (or 5.06% on average). So crucially, the FRN does not suffer from the broader interest rate volatility, and at the same time, actually benefits from a higher coupon as the increase in the bank rate feeds through to a higher Libor, thereby boosting total returns.
From this example, we can see the clear advantages of floating rate instruments over fixed rate equivalents in a rising interest rate environment.
It is important to note, however, that as non-investment grade instruments, there is still exposure to wider moves in credit spreads within the high yield floating rate market. From table 1, we can see that spread duration for the high yield floating rate market is 2.1 years. Accordingly, if spreads were to widen on average by 100bps to 500bps, there would be an associated capital loss of around 2.1%, and vice versa if spreads were to tighten.
However, the spread duration is around half that of the more traditional high yield universe at 4.1 years. This means that in times of risk aversion and widening credit spreads, the impact on prices for the high yield floating rate market should be comparatively lower. During the recent weakness in late July and August 2014, we can see this expected relationship did indeed play out (see figure 3).
On the other hand, if spreads were to tighten from current levels, we would expect the high yield floating rate market to see an associated capital gain smaller than the more traditional high yield universe, given lower spread duration and, on average, a smaller degree of call protection (a provision designed to protect bondholders by preventing the early redemption of a bond).
A globally diversified market
In terms of the underlying issuers, the global high yield floating rate market is well diversified across different regions and industries (see figure 4).
At present, there is a bias towards the sterling and euro markets, driven in part by the trend for European issuers to refinance bank debt in the bond market.
The other major trend we can see is a preponderance of industrial rather than financial issuance. We expect this to continue in the short term, increasing the proportion of industrial issuers in the market over time.
|Table 2: Selection of new issues in 2014|
|Issue date||Issuer||Sector||Issue spread (bps)||Maturity||Amount issued (million)||Country|
|Feb-14||Innovia Group||Capital goods||500||Mar-20||€342||UK|
|Mar-14||Premier Foods||Consumer non-cyclical||500||Mar-20||£175||UK|
|Mar-14||Kerneos Tech Group||Basic industry||475||Mar-21||€150||France|
|Apr-14||Eden Spring||Consumer non-cyclical||550||Apr-19||€210||Israel|
|May-14||Avis Budget Group||Services||275||Dec-17||US$250||USA|
|Jun-14||Dry Mix Solutions||Basic industry||425||Jun-21||€550||France|
|Source: M&G, Bloomberg, 2014.|
Drivers of returns and key risks
For investors in the high yield floating rate bond market, the key factors that will influence returns will be:
- Credit spreads – Income, in the form of a credit spread over Libor, is likely to form a major component of total returns, particularly in a low interest rate environment. As the issuers in this market are rated below-investment grade, the corresponding credit spread that investors receive is higher than in other fixed income markets to compensate them for this risk (currently around 400bps).
As mentioned previously, returns will also be governed by changes in credit spreads. At a time of tightening spreads, returns will be boosted by capital gains; at times of widening spreads, investors will see capital losses.
- Interest rates – The path of short-term interest rates will also have an impact. If short-term interest rates fall, total returns will also fall as the coupon is automatically reduced, and vice versa should short-term rates rise.
- Default rates – If high yield default rates increase, investor returns would be hit as individual bonds can suffer from writedowns of capital during a bankruptcy process.
High yield floating rate notes vs. leveraged loans
Given the characteristics outlined in this article, it is no surprise that high yield FRNs share many of the same investment characteristics as leveraged loans (floating rate coupons, senior position in the capital structure, non-investment grade issuers).
However, there are some small but important differences between the two asset classes. Most important of all for non-institutional European investors is the fact that high yield FRNs are eligible for inclusion in authorised open-ended funds (aka ‘UCITS eligible’), whereas leveraged loans are currently considered eligible only for institutional investors. To date, this has meant that non-institutional investors could only access this market through closed-ended vehicles such as investment trusts.
However, with the emergence of the high yield floating rate market, non-institutional investors across Europe will be able to access this market using a traditional open-ended fund.
|High yield FRNS||Leveraged loans|
|Coupon||LIBOR + fixed margin||LIBOR + fixed margin|
|Credit rating||Non-investment grade||Non-investment grade|
|Security||Typically first lien / senior secured||Typically first lien / senior secured|
|Liquidity||Daily trading T+3 settlement||Less liquid, uncertain settlement|
|Public/Private||Public information only||Public and private information|
|UCITS eligible||Yes – can be included in open-ended funds sold to non-institutional investors||No – limited to institutional investors only. Non-institutional investors can only gain exposure through closed-ended funds|
Mitigating default risk
Examples of high yield FRNs
Vue is a leading cinema operator in the UK and northern Europe. A consumer-focused business generating a resilient cashflow, we believe Vue is well placed to benefit from the bounce back in UK consumer confidence and retail spending.
The largest shale gas exploration and production company in the US, with an approximately US$18 billion market capitalisation, Chesapeake benefits from a strong asset base across the major onshore gas fields and an improving balance sheet.
Italian mobile telecom business Wind is one of the largest issuers of high yield bonds in Europe. Its senior secured bonds are well supported by a strong underlying cashflow.
We view default risk as the key risk to be managed through the cycle, as this is the one driver that can lead to a permanent loss of capital. How can this risk be managed? We think there are three key mitigants:
- Diversification – Ensuring that any investment in this market is diversified across geographies and industries helps protect investors against major idiosyncratic shocks that could precipitate defaults in any one industry or region.
- Credit analysis – As non-investment grade companies, the business, financial and legal risks associated with each bond issued can be very complex. Consequently, having the expertise and capability to assess these risks on a case-by-case basis is crucial.
- Investing in senior secured instruments – Instruments that are senior secured or first lien have prior claim over an issuer’s assets in the event of a bankruptcy. This means recovery rates are much higher on average than unsecured liabilities (see table 3). High yield FRNs are often senior secured instruments or sit alongside loans in the capital structure. Using the data below from the US as a proxy, we would expect recovery rates for this market to be in the 60-80% range over the long term.
|Table 3: Average North American non-financial corporate debt recovery rates measured by ultimate recoveries, 1987-2013|
|Lien position||Emergence year||Default year|
|Senior secured bonds||67.5%||63.6%||63.5%||n/a||71.2%||63.5%|
|Senior unsecured bonds*||4.5%||36.0%||48.1%||n/a||39.3%||48.1%|
|* 2013’s senior unsecured bond recovery rate is based on five observations|
|** Includes senior subordinated, subordinated, and junior subordinated bonds. 2013’s subordinated recovery rate is based on observation|
|Source: Moody’s, August 2014.|
A new tool
As we hope to have illustrated in this article, high yield floating rate bonds offer a unique combination of characteristics for fixed income investors, namely exposure to credit spreads alongside materially lower interest rate risk. Consequently, we believe the development of this market will give bond investors a new tool that not only mitigates the potential headwinds of higher interest rates, but also gives them something that actually benefits from the next phase of the monetary policy cycle.
The yield-dampeners – will interest rates inevitably rise when QE ends?
Speak to the majority of investment strategists and economists in the world today and most will tell you that now is not the time to buy fixed income assets, particularly government bonds. Most will point to the low level of interest rates, suggesting that bond yields can only go one way and that is up. After the ‘taper tantrum’ of 2013, many predict that the catalyst for a sell-off in fixed income assets could be the end of quantitative easing (QE) by the US Federal Reserve (Fed). At the current pace of tapering, the Fed’s QE experiment is due to cease in October this year.
In this latest issue of our Panoramic Outlook series, I present an alternative view to the consensus thinking that interest rates must inevitably rise. To do this, I investigate a number of dynamics in fixed income markets that have surprised investors during this period of extraordinary monetary policy. There are a number of possible reasons to suggest that the market may not see a material increase in bond yields when the Fed finishes QE. Firstly, given the fragility of the global economic recovery and high level of debt in the US economy, it is unlikely that interest rates will return to pre-crisis levels, limiting the potential downside to fixed income assets. Secondly, there are some powerful structural deflationary forces which are helping to keep inflation low. Finally, a strong technical factor – the global savings glut – is likely to remain supportive to fixed income assets as is firm demand from large institutional pension funds and central banks.
The current state of play
Over the course of 2014, Fed Chair Janet Yellen and the Federal Open Market Committee (FOMC) have continued to slow the pace of its large-scale asset-purchase programme. The four rounds of QE have undeniably had an impact on bond yields, with the Bank of International Settlements estimating1 that the five-year forward 10-year rate is around 90-115 basis points lower than it would otherwise be. Today, the Fed owns around $2.4 trillion of US government debt, as shown in figure 1.
The question that markets are grappling with right now is what will happen when this huge source of demand for US Treasuries, namely the US Federal Reserve, steps away from the market?
Looking at the past behaviour of 10-year US Treasury yields does not provide great insight into the future path of yields. For example, as shown in figure 2, the 10-year Treasury yield fell by around 175 basis points during QE1 before rising back up to pre-QE levels. At one point during QE2, yields increased by around 125 basis points before falling back to the 3% level. During QE3, the 10-year yield fell by around 20 basis points. In 2013, markets threw a ‘taper tantrum’ following the then-Fed Chairman Ben Bernanke’s testimony to Congress and yields increased by over 100 basis points. This year, as the Fed has gradually reduced asset purchases, yields have actually fallen by around 50 basis points. It is too simplistic to suggest that the behaviour of bond prices is simply a function of whether the Fed is doing QE or not. There must be other forces at work in the bond market.
Government bond yields – lower for longer?
It is a valuable exercise to attempt to identify the other forces at play in the US government bond market. Could government bond yields possibly stay lower for longer, continuing to surprise the consensus?
As the world’s largest and deepest government bond market, US Treasuries represent the risk-free rate of return. That is, the interest an investor would expect from an absolutely risk-free investment over a period of time. The risk-free rate acts as an anchor for other fixed income assets such as investment grade and high yield corporate bonds. At this point in the economic and credit cycle, there appears to be what I call three key yield-dampening forces (or ‘yield-dampeners’) at work that investors should be aware of.
Yield-dampener 1: the Fed funds rate will remain at a low level for a long time to come
Nominal US interest rate cycles have exhibited progressively lower peaks and troughs over the past 30 years (see figure 3). There are a number of reasons for this. Firstly, declining inflation was an important contributor to the fall in interest rates. Secondly, the move to make central banks independent of their respective governments was a significant step in achieving credibility. Thirdly, the adoption of an inflation-targeting or price stability approach to monetary policy was also important in anchoring inflation expectations for both consumers and the market.
The most important insight we can gain about the Fed funds rate is whether it is helping to stimulate or restrict economic growth. Broadly speaking, monetary policy can be seen as expansionary if the policy rate is below the natural rate of interest (the rate consistent with output being at its potential), with the gap between the rates measuring the extent of the policy stimulus.
The problem for economists is that the natural rate of interest is unobservable, but it can be tracked with a model2 that identifies the interest rate that would prevail when output is at its potential. Using a model developed by economists at the US Federal Reserve, a current estimate of the natural rate of interest is just -0.4% (see figure 4). The estimate has largely trended lower since the 1960s. Apart from a couple of brief periods over the past 15 years, the real interest rate has been below the natural rate of interest, indicating an expansionary setting of monetary policy. This has encouraged the build-up of debt and risk-taking behaviour.
Nominal US rate cycles have moderated over time as leverage has grown within the US economy. This will likely continue for the current cycle, suggesting a much lower peak in interest rates than experienced during previous tightening cycles. The high levels of leverage mean that it will require fewer and more gradual rate hikes to dampen economic activity. As a result, the Fed will not have to step on the brakes as hard as it used to in order to slow down the economy and guard against inflation. The world is addicted to low interest rates, meaning that rate cycles over the next decade could consist of fewer rate hikes.
Think of an elite marathon runner in his prime. He would inevitably have a low level of body fat compared with the average person. In retirement, given the lower levels of physical activity and less focus on diet, our marathon runner puts on weight (a lot of weight). With the lack of training and increase in body size, the runner inevitably slows down and cannot compete at the same level that he used to.
This analogy is useful in describing the US debt binge at all levels of the economy – households, corporates, banks and government. Total debt to GDP stands at around 350% as shown in figure 5. For more than a generation, governments, consumers and companies were able to borrow with impunity, knowing that persistent inflation would inflate away their debts. Today, not only are these economic agents trying to fight their way out of this debt morass, deflation could increase the real value of what they owe. Economists call this paradox ‘debt deflation’. The US economy cannot work off the excess leverage that has built up over a period of 30 years unless interest rates remain low.
Despite some moderation in recent years, the deleveraging that has occurred in the US economy is not enough. These high levels of debt are sustainable only because interest rates are at levels not seen since the 1950s. To use our runner analogy, we would not expect our retired and overweight marathon runner to compete at the level he once used to. US companies, households, banks and even the government cannot cope in a world of much higher interest rates without the economy plunging back into recession. Interest rates and yields may rise from current levels, but they are unlikely to return to pre-crisis levels.
Yellen has her own monetary policy rule book
Economists and markets are still getting used to having Janet Yellen as Fed Chair. Having worked in the Fed system and the White House for a combined 16 years, reviewing her long academic career and research papers can provide an interesting insight into her thoughts on the conduct of monetary policy.
Yellen has written a number of papers with her husband George Akerlof, an American economist and winner of the Nobel Prize in Economics in 2001. Yellen’s most-cited paper, “The Fair Wage – Effort Hypothesis and Unemployment”3, builds a model in which the amount of effort that a worker puts into their job depends on the difference between the wages they are getting paid against their perception of what is a ‘fair wage’. The hypothesis is that the bigger the difference, the less hard the worker works.
Another paper written with Akerlof, and perhaps the most relevant paper for monetary policy, was written in 2004. In “Stabilization Policy: A Reconsideration”4 the authors conducted a review of the existing literature, disagreeing with Milton Friedman’s view that countercyclical policy cannot affect the average level of unemployment and output. Again, Yellen has focused on the labour market, coming to the conclusion that being unemployed in a recession is worse than being unemployed when times are good. The authors conclude that “there is a solid case for stabilization policy and that there are especially strong reasons for central banks to accord it priority in the current era of low inflation”. This is a marked difference from the Alan Greenspan-led Federal Reserve, which was hesitant to raise interest rates in the face of a boom, but quick to reduce rates when the economy entered into recession.
The next paper, “Waiting for Work”5, was written in 1990, again authored with Akerlof and economist Andrew Rose, focuses on a phenomenon known as ‘lock-in’. The authors find that “workers who are laid off in a downturn rationally wait to accept jobs until business conditions improve. Workers voluntarily remain unemployed in recessions if they gain through waiting for permanently higher wages which are available in the new jobs which appear during expansions”. Yellen, Akerlof and Rose proved that workers hired in booms “lock-in” higher wages whereas workers hired in busts suffer lower wages. This partly explains why Yellen expects the participation rate to pick up in the future as workers increasingly believe the US economic recovery will last.
In Janet Yellen, the US Federal Reserve has appointed a very strong academic economist who has focused on the key economic resource of labour for a large part of her academic career. Much like Ben Bernanke who was a pre-eminent expert of the US Depression before joining the Fed and saw the economy through the dark days of the credit crisis, it appears that Janet Yellen might be in the right place at the right time to lead the FOMC. In terms of the Fed’s dual mandate of price stability and full employment – provided inflation behaves – Yellen will likely prefer to keep monetary policy accommodative. This was highlighted in Yellen’s most recent Congress Testimony, where she stated “My own expectation is that, as the labour market begins to tighten, we will see wage growth pick up, some to the point where nominal wages are rising more rapidly than inflation, so households are getting a real increase in their take home pay. If we were to fail to see that, frankly, I would worry about downside risk to consumer spending.”
Arguably there are now three key economic indicators to watch. Inflation, unemployment and wage growth. Without wage growth, it is unlikely that Chair Yellen would be calling for a rate hike any time soon. The FOMC has a new monetary policy rule book.
Yield dampener 2: weak economic data and structural deflationary forces
Arguably, the greatest force causing rising bond prices has been a falling inflation premium that investors place on owning government debt. The performance of long-dated government bonds this year suggests that buyers believe inflation will remain at current levels (or lower) for a long time to come. This is to be expected given that the economic data has largely underwhelmed economists’ forecasts since February, as shown in figure 6. The Fed has continually stated that the pace of monetary policy tightening is data dependent. Many have blamed poor weather for the run of weak data but it seems that the Fed is justified in its dovish stance for now.
When determining the inflation outlook, it is important to acknowledge that there may be structural deflationary forces at play in the global economy. These include debt deleveraging, globalisation and technological advances that result in large productivity gains. Given these structural forces, there is a strong case for examining the Japanese fixed income experience as it may provide some insight into the future behaviour of G7 bond yields.. See The ‘Japanification’ of Government Bond Markets for further insight.
The ‘Japanification’ of government bond markets
Back in the late 1980s, Japan was a shining example for the rest of the world in the eyes of many economists. Most saw a clear edge in Japan’s competitiveness relative to the US across a broad range of high-tech and manufacturing mass-produced tradable goods. Japan had recovered from the devastation of World War II and its economy was producing year after year of solid growth.
At the time it was argued that the Japanese work ethic was far superior to that of the West. This would likely lead to substantial benefits in labour productivity. In addition, Japan’s high savings rate and slow population growth would give the economy an edge in an increasingly globalised world. Of course, Japan’s proximity to China and the Far East would give it access to a vast pool of workers to which it could outsource lowly skilled and low-paid jobs. This would allow the Japanese economy to specialise and benefit from its large pool of highly educated workers.
Unfortunately for the Japanese economy, the reality turned out differently from the confident forecasts. Today, the economy is around 40% smaller than observers predicted back in the late 1980s, having grown at a very slow pace over the last two decades. Japanese individuals and companies have spent much of the past 30 years working off the debt that they accumulated during the 80s. Banks saddled with bad debts refused to lend, preferring instead to buy Japanese government bonds.
Recognising the economic malaise, the government offered new stimulus plans through higher public spending, although with little impact on the real economy. This resulted in government debt-to-GDP ratio increasing from around 70% in the late 80s to over 200% today. The central bank eventually chipped in as well, reducing interest rates to zero and implementing QE in 2001.
So what are the lessons that fixed income investors can learn from the Japanese experience?
For investors, one trade that has always lost money, over any reasonable time period, has been the shorting of Japanese government bonds (JGBs). This trade, unique in its consistency, developed its own name: “the widow maker”. Over the past 24 years, JGB yields have fallen relentlessly from a peak of around 8% in 1990 to around 0.62% today. Despite the great monetary experiment of “Abenomics”, the widow maker is alive and kicking.
History might not repeat itself but it does rhyme. As shown in the accompanying chart, US, German and UK government bonds yields are following an eerily similar path to JGBs in the early 90s. The question has to be asked: is shorting developed market government bonds the new widow-maker trade?
Yield dampener 3: the global savings glut
Another reason that investors are surprised by the fall in yields this year despite the reduction of Fed purchases is because of the strong ‘technical’ support for the asset class. This is often difficult to identify in advance and is much harder to measure than economic variables such as unemployment or inflation. Some of the strong technical support for US Treasuries is illustrated in figures 7 and 8.
Low yields on government debt during the last rate hiking cycle bamboozled the then-Fed Chairman Alan Greenspan. It was his successor, Ben Bernanke, who presented a plausible explanation in 2005. By his reckoning, falling government bond yields and the inverse yield curve was being caused by a ‘global savings glut’.
Bernanke proposed that a decade-long development of global savings was the result of a combination of strong technical factors. Firstly, the strong saving motive of ageing developed nations such as Germany and Japan was an important factor. Secondly, Bernanke proposed that the developing world was changing from being a net user to a net supplier of funds in international capital markets. The proceeds of war chests of foreign reserves that the emerging economies had built up in response to earlier crises were being used to buy US Treasuries and other assets.
Figure 7 represents the major foreign holders of US Treasuries: China, Japan and Belgium. That’s correct; Belgium – a small country with a population of 11 million – is the third-largest holder of US government bonds. However, it is highly unlikely that Belgium is buying all those bonds, and some have speculated that the increase in holdings over the past eight months reflects the secret buying trends of other countries using Brussels as a financial centre. It could be China, it could be central banks, it could be the fact that Euroclear (the custodial service provider) is based in Brussels. Or it could be none of the above. What we do know, is that demand for US Treasuries has accelerated in 2014. The global savings glut has not disappeared.
Another strong tailwind for fixed income markets is blowing due to the fact that both equities and fixed income assets have had such a great run over the past couple of years. Both public and private pension plans are now better funded and are increasingly looking to lock in their gains before volatility begins to pick up again.
The managers of defined benefit schemes would like to lead a cautious life. It is vitally important that they make enough money to honour the promises they have made to their employees. For this reason, their allocation to safer assets – like fixed income – has historically been quite high.
Many schemes were over-funded around the start of the millennium, meaning defined benefit managers could sleep well at night. This changed after the financial crisis in 2008, when the returns of the equity allocation of many funds nose-dived into negative territory. The memories of that episode have remained fresh, with many managers vowing to de-risk their portfolios if they ever got back to fully-funded status.
Fortunately for the employees of the biggest companies in the US, many pension schemes are now clawing their way back to being 100% funded (see figure 8). The Milliman 100 Pension Funding Index – which represents the funded status of the 100 largest corporate defined benefit funds in the US (around $1.5 trillion of assets) – showed that the funded ratio rose to 87.3% at the end of 2013 from 77.3% a year earlier, representing a deficit of $193 billion. The increase in the funded ratio during 2013 was the largest percentage gain ever experienced in the 14-year history of the Milliman survey.
We would expect that as pension plans get ever closer to being fully funded, pension managers will continue to ‘reverse rotate’ out of equities and into fixed income and focus on liability-driven investing strategies to ensure future payments are met.
Will government bond yields move higher from current levels or will the “yield-dampeners” limit the damage?
It appears that the question of where yields move from current levels is more complex than first meets the eye. This reflects the uncertain and experimental nature of unconventional monetary policy such as QE programmes. Given this uncertainty, it is a useful exercise to question the market consensus that yields must rise.
It is very much possible that those looking for yields to rise back to pre-crisis levels when QE ends may be disappointed. Be wary of the yield-dampening forces at play in the US treasury market. In addition, the ‘yield-dampeners’ could easily be applied to the UK or European government bond markets, potentially providing a useful lesson for the future path of yields. This will impact the attractiveness of other fixed income assets such as investment grade and high yield corporate bonds. Arguably, ultra-low cash rates and a stable interest rate environment for government bonds would provide a solid base for corporate bond markets as investors continue to seek positive real returns on their investments.
The emerging markets rebalancing act
Over the past year, investors’ perception towards emerging market bonds changed from viewing the glass as being half full to half empty. The pricing-in of US ‘tapering’ and higher US Treasury yields largely drove this shift in sentiment due to concerns over sudden stops of capital flows and currency volatility. For sure, emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years. In this issue of our Panoramic Outlook series, we examine the main channels of transmission, policy responses and asset price movements, as well as highlight the risks and opportunities we see in the asset class. Our focus in this analysis is on hard currency and local currency sovereign debt.
Some emerging market countries are more advanced than others in the rebalancing process, while others may not need it at all. Also relevantly, the amount of rebalancing required should be assessed on a case-by-case basis, as the economic and political costs must be weighed against the potential benefits.
Generally, the necessary actions include reducing external vulnerabilities such as large current account deficits (especially those financed by volatile capital flows), addressing hefty fiscal deficits and banking sector fragilities, or balancing the real economy between investment and credit and consumption. It is worth noting that not all countries have vulnerabilities. And those that do not are the ones that should be bought in sell-offs like the ones we saw in June and August 2013, as well as early 2014 (see chart 1).
EM hard currency debt – higher Treasury yields
Emerging market (EM) hard currency debt is issued by sovereign (or quasi-sovereign) entities in currencies other than their local currency, usually in the US dollar. The largest issuers in this market are currently Mexico, Russia, Indonesia, Venezuela and Turkey. Returns for hard currency debt are driven essentially by credit spreads and US Treasury movements. In turn, they tend to correlate positively with Treasuries.
We expect US Treasury yields to gradually move higher towards neutrality of around 4% over the next few years, which should weigh slightly on EM hard currency debt returns. But with the tapering of asset purchases already priced in and given low inflationary pressures, the Fed can remain dovish on its guidance in the near term. As such, Treasury performance in 2014 should improve compared with negative returns in 2013, which was one of the headwinds that weighed on EM investment grade last year.
EM local currency debt – weaker currencies
EM local currency debt is issued by governments in their local currencies. The largest issuers in this market are currently Brazil, Mexico, Poland, South Africa, Malaysia and Russia. Returns for local currency government debt tend to be driven by global yield, country-specific factors such as inflation and monetary policy expectations, risk premia and currency movements. A basic overview of the different emerging market indices is shown in chart 2.
While the transmission channels tend to be always the same, the degree of positive or negative impact of a depreciating currency differs depending on a variety of factors. These are essentially the openness of the economy (through trade, services and the capital account), as well as the currency regime. Unlike prior crises, as in pre-2001 when most of the EM investable markets had fixed or intermediate regimes such as currency pegs, nowadays, 58% of the hard currency benchmark and 78% of the local currency benchmark comprise countries that have floating currency regimes as classified by the International Monetary Fund (IMF). A floating currency arrangement acts as an economic buffer in an environment of less abundant capital. It minimises drawdowns on foreign exchange reserves and it can help adjust the current account if an adjustment is needed due to changes in terms of trade or if a country needs to regain competitiveness. This is important as adequate levels of reserve coverage are a necessary condition for the servicing of hard currency debt. There is vast literature analysing past crisis episodes under fixed, intermediate and floating currency regimes; however, the findings generally suggest flexible regimes are the least vulnerable as the currency acts as a shock absorber. A recent study1 that looked at the relationship between exchange rate regimes and crises came to the conclusions summarised in chart 3. The study uses two different currency regime classifications: the IMF and the Ilbetzk, Reinhart and Rogoff (IRR) classifications.
Under the IMF classification, the study showed that pegged currency regime countries go through banking, currency or debt crises the most often, while when using the IRR classification, intermediate currencies are the most at risk. Under both classifications, countries with floating exchange rate currencies have historically suffered the fewest crisis episodes.
Since markets began to anticipate Fed tapering in the middle of last year, most emerging currencies have depreciated in nominal and real terms in either an orderly process with minimal reserve loss (including free floaters such as South Africa, Mexico or Colombia) or in an abrupt process (including the dirty pegs or managed currencies in countries such as Argentina, Kazakhstan and Ukraine). A simple gauge of determining whether a currency is fundamentally undervalued or overvalued is the real effective exchange rate. This measure seeks to assess the value of a currency against a basket of currencies based on nominal exchange rates and the changes of relative prices. The fundamental notion is that large deviations signal over or undervaluation, ceteris paribus (ie no fundamental changes such as terms of trade, productivity levels or other structural changes in an economy) (see chart 4).
It is worth highlighting that currency depreciation does not necessarily equate to a currency crisis. A depreciation may not be negative for a credit if there are little or no currency mismatches on the balance sheet of the public and corporate sector, if the country enjoys credibility regarding its inflation targeting regime and remains vigilant of inflation expectations, and if the fiscal impact is not large. It can even be positive if the country has sectors that can benefit from increased competitiveness or if the impact on its fiscal accounts is positive, for instance in the case of oil exporters. The recent 18% devaluation of the Kazak tenge is an example. Despite the devaluation, Kazakhstan spreads did not widen. We are comfortable investing in hard currency debt of such countries where depreciation does not represent a currency crisis. The currency impact for investors can be significant so it is important to get the asset allocation and security selection calls right. For example, in South Africa the local benchmark fell 5.4% between 15 September and 31 December 2013, while the hard currency benchmark rose 2.3% (in US dollar terms). The South African central bank did not intervene through the period and the country’s net international reserves remained stable. This differs materially from 10 years earlier, when the country’s net reserves were negative due to its short US dollar exposure through forward sales. Fair value is difficult to determine with precision. There are various approaches for doing so. The IMF, for example, provides three approaches, which often lead to conflicting results. (The relevant methodology can be seen here).
Purchasing power parity (PPP) metrics, on the other hand, are simple to construct, but fail to take into consideration several elements that affect valuations, such as structural changes in an economy, terms of trade and productivity changes. However, they can usually highlight large deviations. Some countries have already started seeing a rebalancing and reduction of their current account deficits (eg India, Indonesia), which has in turn helped to support their currencies and local bond markets. Other currencies appear theoretically cheap (South African rand, Turkish lira), but this has not yet been reflected in the narrowing of their current account deficits. In terms of positioning, we favour currencies with low imbalances such as the Mexican peso and Philippine peso, or high carry currencies that have already started rebalancing like the Indonesian rupiah and Indian rupee.
Higher interest rates
Various EM central banks, including in Brazil, Indonesia and South Africa, have had to tighten monetary policy pre-emptively in order to anchor inflation expectations or reactively respond to currency pressures, particularly in countries like Turkey where large current account deficits require higher interest rates to attract financing. On average, nominal interest rates stand at 7% and real rates around 3%. We believe that, like US Treasury yields, medium- to long-term real yields on local currency debt still need to rise, but part of the adjustment has already been achieved (see chart 5). Weaker currencies and higher interest rates will tend to reduce growth, particularly in countries that do not stand to benefit from improved competitiveness or gains on non-commodity exports. The IMF has maintained its growth projections for emerging economies unchanged in its January report (5.1% for 2014 and 5.4% for 2015), but we expect downward revisions at its upcoming April report as some key economies (Russia, China) are facing additional headwinds. A combination of higher interest rates and lower growth will require a (potentially pro-cyclical) fiscal adjustment in a few countries that need to stabilise their debt dynamics.
The World Bank has recently warned of a potential material decline in capital flows to emerging markets in a scenario where developed market long-term rates increase by 2%. However, based on recent trends (flows have already been declining), its baseline modelled scenario expects flows to decline slightly from current levels. This is also corroborated by forecasts from the Institute of International Finance (IIF), which sees flows declining in 2014 but then rebounding in 2015 (see chart to the left). In terms of the bond market, most countries have been able to borrow in the international capital markets since the fear of tapering began and EM dedicated funds started seeing steady outflows. In fact, the pace of issuance is back to past years’ trends, having recovered from the slowdown during mid-2013. Should the event of a sudden-stop emerge, however one factor that can help smooth out capital flows is the presence of official lenders such as the IMF. While there are few countries that for ideological or political reasons would be unlikely to agree to a funded programme, there are some that would be inclined to do so as a last resort. Countries with strong policy framework have access to facilities such as the Flexible Credit Line (FCL) or Precautionary and Liquidity Line (PLL), enabling them to borrow at short notice if needed. Currently, the IMF has $415 billion in forward commitment capacity (FCC), its main measurement of lending capacity, which is the equivalent of 75% of the non-FDI portfolio flows that was estimated to have gone into emerging markets in 2013. Countries that require an adjustment but offer no response or sub-optimal responses will underperform and will be particularly vulnerable in a sudden-stop scenario. Sub-optimal responses include insufficient fiscal or monetary tightening (if required), restrictions on capital outflows, multiple exchange rate regimes, price controls, foreign exchange reserve depletion and/or maintenance of overvalued exchange rates. Countries that we have concerns about on this front include Venezuela, Ghana, Mongolia and Nigeria, as well as a few additional countries in the Caribbean and Sub-Saharan Africa.
One of the toughest parts of rebalancing will be fiscal adjustments for countries that are running large budget deficits or where an additional tightening is needed to anchor inflation or debt dynamics. Brazil, Argentina, Venezuela, Serbia, Ukraine and Ghana are cases in point. This is likely to be one of the last phases of the adjustment, as it entails political costs and governments often do it on a reactive mode. Examples would include being under pressure from the markets (wider spreads and reduced access to capital markets), rating agencies (as the credit is downgraded) and/or from performance criteria or prior actions as required by an IMF programme, if the country is subject to one. The pressure normally builds up in this order. The fact that governments lack room to make large fiscal adjustments ahead of elections, and with so many elections due this year, means this adjustment will be postponed. Back to top
We believe the credit quality in EM bonds has peaked as some of the factors that helped improve creditworthiness – namely reserve accumulation, easy global and domestic monetary conditions – have deteriorated in recent months. For example, headwinds to EM include a declining rate of trend growth in critical countries such as China and a deterioration in the terms of trade that many EM countries currently enjoy. However, the widening of sovereign hard currency spreads on an absolute basis is already pricing in a one notch downgrade on average.
For these reasons, we expect downgrades in Brazil, the Bahamas, Bermuda, Bahrain and Mongolia and upgrades in the Philippines, Colombia, Paraguay and Angola. On a relative basis, EM bonds have underperformed high yield, investment grade and peripheral European sovereigns, so the market is already pricing in some credit deterioration (see chart 6).
China is the most critical rebalancing act due to the sheer size of its economy and impact on global markets. We believe that a structural reduction in trend growth is inevitable, the main question being whether it will occur in an orderly or disorderly manner.
In addition to economic risks, political and policy risks in emerging markets will shape asset prices in many countries. There are elections in 15 key countries (see chart 8), including countries such as India, Indonesia, Turkey, South Africa, Brazil and Ukraine. Popular discontent and political confrontation in Venezuela and Thailand are also being watched closely. Political risk is a very subjective element. While there are dozens of indices that rank countries based on their institutions, corruption, security, rule of law, etc, assessing how much that is worth in terms of spreads or currency valuations is never an easy task. Expectation of political or policy change often increases demand for safe assets and capital flight, both from locals and foreigners. That usually starts with currency weakening, but can also spill over into spreads in countries where the currency is more heavily managed or when it is accompanied by reserve loss. Countries with stronger institutions and low probability of policy change, such as Chile, see little to no volatility, while for others, like Ukraine, future prospects of economic policy and future alliances will be materially changed. We see upside risks (too much political risk priced in) in Indonesia, balanced risks in India, Brazil and South Africa, and downside risks in Ukraine.
While we believe the authorities are aware of the challenges, they are facing various delicate policy choices:
- allowing investment growth to decline gradually, but without producing a hasty crash in its economy or in sectors such as the property market
- steering the financial sector into greater foreign exchange and interest rate flexibility
- reducing the pace of credit creation
- allowing market forces to determine credit risk and reducing moral hazard
- addressing corruption and fending off vested interests in state-owned enterprises
- increasing transparency in financing operations of shadow-finance entities and local governments
- reducing income inequality and managing social pressures as the economy slows
Some of these challenges are starting to be addressed (some currency and interest rate flexibility, increasing exceptions to the one child policy as demographics worsen), but clearly much more remains to be accomplished. Supportive factors include China’s large net international asset position, as well as its high domestic savings. We believe the markets are too fixated on the pace of growth in China. Instead, we would rather see lower, but higher quality, sustainable growth, than a particular headline number (see chart 7).
We remain vigilant of the potential negative spill-over from China on emerging markets and are managing these risks by carefully selecting our direct China exposure, as well as screening non-Chinese exposure to credits or currencies that can be negatively affected by a decline in commodity prices (particularly industrial metals). The latter includes weaker credits with large current account and/or fiscal deficits which will be under pressure given a material decline in terms of trade (for example, Mongolia, Zambia and the Chilean peso).
The continued adjustment of emerging market sovereigns towards an environment of higher rates and lower capital flows presents investment opportunities in the asset class. Valuations have improved in all three areas (currencies, local rates and spreads) on an absolute and relative basis. However, asset allocation between sovereigns (hard currency and local currency) and corporates and careful country and security selection remains key. Our preference is for sovereigns that are resilient to lower capital flows, have manageable debt burdens, stable foreign exchange reserves and/or resilient banking sectors. Among more vulnerable countries, we may favour those that have started taking policy steps in the right direction. We also prefer quasi-sovereigns/corporates that benefit from currency weakening, such as exporters, or that are exposed to countries we deem to be resilient. We have selectively taken profits on certain long US dollar positions in high carry countries where rebalancing is already under way. Back to top