Duh! It should not come as a surprise that, after years of low rates, the common “advice section" on where to find attractive income opportunities reads like an all-encompassing horoscope: high-dividend stocks, MLPs, junk bonds, REITs, etc. The reasonable question to ask, then, is whether those “usual suspects” have become way too mainstream (you already know the answer). With two darlings now in the danger zone from a technical perspective, namely the U.S. 10-year and utilities (stocks), both very much related to the levels of rates and their anticipated future direction, our focus on yield should take a different angle altogether.
Why are investors still looking for yield to begin with, especially in light of the fact that equities have delivered more than stellar returns? The answer may only be somewhat obvious: From a risk-management perspective, fixed income instruments are still perceived as a diversifier to equity exposure and, consequently, have a “designated function” within portfolio construction. On the other hand, most retail investors have still not fully bought into the equity story (or, similarly, the economic recovery) and continue to search for income and diversifying elements to their more traditional bond exposure.
Early last summer, I went on record to promote a seemingly attractive “swap” from high yield debt exposure (mainly corporate issues) to emerging market (EM) debt. At that time (July 2014), high yield spreads over U.S. Treasuries were noted at 372 bps, far below the 586 bps long-term average spread (high yield is currently trading at 415 bps). As a result, high yield bonds were neither cheap nor high-yielding. The irony: when spreads were in excess of 2000 bps, around the time of the Financial Crisis, hardly anyone wanted to own high yield. These days, the “junk allocation” remains overbought, partially for income aspirations, but also to serve as an equity proxy.
Emerging market debt, in comparison, still is an “under-allocated” and broadly misunderstood asset class. Not only did most emerging nations move from debtor to creditor status years ago and have since become investment-grade borrowers, but already in 2003 the issuance of U.S. dollar (USD)-denominated EM corporates outpaced sovereign issuances. Nevertheless, the end of last year was a harsh reminder that asset selection and currency preferences are keys to success, especially when the demise of oil and Russia impacted the performance of EM currencies, equities, and fixed income alike. This aside, the asset class still posted a positive calendar year return by the end of 2014, and certainly was worth my suggested “swap,” especially on a risk-adjusted basis.
As a reminder: when investing, we need to focus on fundamentals and long-term trends, and more importantly, avoid mass hysteria. Over the past 20 years, high yield returns have come at an income volatility of 6 percent, with an average coupon of 15 percent (e.g., for bonds rated below Investment Grade at CCC by Standard & Poor’s), and today’s investors are settling for the same risk proposition at yields not even half of this historical norm. Income has become a relative game; zero interest-rate policies (ZIRPs) practiced by global central banks, especially the Fed, have tempted asset allocators to accept choices they would not normally support.
With the greenback now trading at a 12-year high (acknowledging that this trend may not have fully played out), current levels appear to be attractive to “pick up” non-dollar-denominated investments. Whereas it was beneficial to hold emerging market debt denominated in USD rather than local currencies over the past years, market participants may now be experiencing a turning point in the opportunity set—on top of an already-occurring structural transformation of EM debt becoming a serious contender in global allocation choices. Rather than “piling” more money in domestic, junk-rated fixed income choices, yield and quality provided by emerging market issuances appear to be the better risk-adjusted investment choice.
Matthias Paul Kuhlmey is a Partner and Head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to High Net Worth and Ultra-High Net Worth Individuals, Family Offices, and Institutions.
