EM investors go down credit curve to hedge Treasury risks

Thu Jul 3, 2014 12:06pm EDT

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NEW YORK, July 3 (IFR) - Worried about a rise in US Treasury yields, some emerging market investors are shunning high-quality corporate bonds and reaching down the credit spectrum to reduce rates sensitivity in their portfolios.

The strategy could boost total returns at a time when credit spreads have little room to compress further and competition to outperform benchmark indices runs high among fund managers.

"Investing in emerging markets has become a macro exercise, where individual credit stories are less important than US Treasury moves and global liquidity conditions," said Jim Barrineau, co-head of emerging market debt relative at Schroders.

US Treasury exposure has been an important component of performance for emerging market corporate bond funds, accounting for more than a third of the 7% year-to-date return in the asset class this year, according to research from Barclays, as yields have compressed considerably since the start of the year.

But analysts at the bank believe the second half of 2014 will see a reversal of fortune in the Treasury market, and that the yield on 10-year Treasuries could top 3.10% by year-end.

In the past week, 10-year Treasuries have widened by 15bp and the stronger-than-expected US jobs data will only add to the risk of a further spike in yields.

"The challenge for EM corporate bond managers is... to prepare for a world where there is still some upside for spreads but a very large risk of a rates sell-off," Barclays strategist Aziz Sunderji wrote in a note to clients at the end of June.

He recommends investors increase their holdings of high-spread products, such as lower-rated corporates and callable subordinated bank debt, while cutting the duration of their portfolios.

Many investors appear comfortable taking on additional credit risks. "Given where we are in the credit cycle, we don't expect a significant rise in default risks, so we are comfortable taking a bit more credit risk and less duration all else being equal," said Damien Buchet, head of emerging markets fixed-income at AXA Investment Managers.

While demand for new issues has been strong at both ends of the credit spectrum, blue-chip corporates have come to rely increasingly on demand from high-grade investors in the US and Europe to generate momentum for new deals.

"Emerging market accounts need to have some exposure to blue-chip corporates, but they are not the drivers and they don't put in anchor orders anymore," said an origination banker covering Latin America.

Recent issues from Mexican bread and snacks company Grupo Bimbo and Chilean state-owned copper producer Codelco both saw limited involvement from dedicated emerging markets investors.

Bimbo (BBB/BBB) recently sold 10- and 30-year bonds at yields of 3.925% and 4.875% respectively.

"On an absolute value basis, it's not really where we want to be," said Buchet at AXA. "A good company does not necessarily make a good investment."

UPPING BETS

At the opposite end of the credit spectrum, however, emerging market investors are upping their bets.

Highly levered Brazilian infrastructure company OAS (B1/BB-/B+) received a nine-time subscribed order book for its US$400m seven-year non-call four bond, which offered a yield of 8%.

Indonesian developer Pakuwon Jati recently sold a US$168m five-year non-call three at a yield of 7.125% in a deal that was 15 times covered. The company had to restructure debt just five years ago.

While most market participants agree rising rates in the US remain one of the main challenges for the asset class, some warn against letting Treasury expectations and absolute yields take precedence over credit analysis.

"Rather than taking a strong directional view on rates, we let the credit selection process drive everything," said Jason Trujillo, senior emerging markets corporate analyst at Invesco.

Managers favouring a more balanced approach say bonds issued by highly-levered companies can badly underperform in a downturn, where low liquidity in the secondary market can easily amplify potential losses.

But even more important is that investors choosing to allocate to lower-rated corporates do so on the back of a strong fundamental view on the sector or the credit.

"If you make the wrong fundamental call, you can end up with losses regardless of what the market is doing," said Trujillo. (Reporting by Davide Scigliuzzo; Editing by Sudip Roy and Marc Carnegie)

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