Where is the yield in floating rate bonds?
Emerging markets assets have endured a lot of punishment during 2021. Emerging markets is of course an imperfect and broad categorisation, but generally speaking, EM equities, local currency and hard currency bonds have all suffered this year due to one or more of a number of factors; high inflation, tighter monetary policy instituted by local central banks, expectations of tighter monetary policy from the Fed, the durability of COVID-19, low vaccination rates and volatility in the Chinese property market.
As we enter the final days of 2021, EM assets, and in particular EM high yield, are now looking very cheap both historically and relative to other sectors of fixed income. Just to apply some numerical context to that underperformance, the spread on the EM high yield index currently sits at 724bp, quite some distance above its 2021 low of 500bp. That is also nearly double the spread on the European high yield index (374bp), despite these two indices having the same average rating and similar credit spread duration.
The root cause of much of this underperformance relates to investor concern over the Chinese high yield property market, and we believe the volatility associated with that market will likely persist in early 2022, meaning we could see additional defaults from issuers rated single-B and below.
However, It is important to consider that China high yield is trading at spreads in excess of 2,000bp; if we believed spreads wouldn't tighten from their currently extreme level by the end of 2022, that would implicitly suggest we viewed a sector-wide default as likely. It is also worth noting that government measures to cool down the property sector are the primary cause of the market's discomfort, and we think it unlikely that Chinese authorities would allow the collapse of one of the country's most significant economic sectors. In our view, provided defaults in the sector are contained to lower rated issuers, the current spread on EM high yield indicates investors have already priced in a fair amount of bad news, and therefore this could be an attractive opportunity for stock selectors.
That said, there are several important considerations for prospective investors. Firstly, timing will be very important and a lot will depend on the Fed’s actions. For example, if persistently high inflation prints were to force the Fed into hiking base rates more aggressively than the market is currently anticipating, we would expect emerging markets to continue to underperform. Additionally, the situation in China still has the potential to impact broader sentiment, and thus investors may want to wait for more clarity on that situation before looking to take advantage of the value on offer. Likewise, current sentiment towards EM as an asset class in general remains poor, and volumes (at least in corporate hard currency bonds) are low, with bonds repricing on very thin trading.
Secondly, while we expect solid corporate fundamentals in emerging markets overall, sovereign fundamentals have deteriorated due to the pandemic. Most countries have less fiscal capacity than developed market countries, and we should begin to see the lagged effects of tighter monetary policy impact EM growth in the next several months, leaving the macro picture in conflict with the corporate fundamentals. Therefore, smart credit and country selection will be crucial, as the wide dispersion we witnessed in 2021 will likely continue. In 2022, avoiding EM’s losers will be as important as picking the winners.
In conclusion, as the market waits for more clarity from the Fed on rates policy and progress from China on its property sector issues, we believe patience is a virtue. However, in the absence of a significant policy error from the Fed, we think the current sell-off in riskier assets might represent the beginning of an intra-cycle dip, and a profound opportunity for investors to achieve some alpha. In our view, keeping a lid on duration risk with relatively short-dated bonds, and investing in those companies that can evidence solid credit fundamentals, diverse revenue streams and good results, will be the recipe for success in EM next year.
Ultimately, while we think EM high yield spreads will grind tighter by the end of 2022, this adjustment may come with increased volatility, so sizing and timing, as always, are critical.