This year’s top 2 asset performers so far have been debt paper with the Emerging Market (EM) debt leading the gains (12.8%) with high yield global bonds just behind in gains.
Hungry for yield and relative safety, the fixed income people have been scooping paper of countries that several years ago one would hardly consider to be paragons of safety let alone their sketchy credit history. Yet debt paper of likes of Poland, Mexico, Peru and Russia are hot: Polish paper is flirting with negative yields while, may we recall, Mexico and Russia have had their bouts with defaults.
In a world with zero yields and very little of available AAA paper, stuff that is just above junk is commanding the premium.
For example, JPMorgan’s USD Emerging Markets Bond Fund (EMB) is heavy on Philippines and Peru paper and the overall rating concentration is inside the BBB and B- range yet the chart of EMB is of envy.
So is the chart of another dollar denominated debt ETF – the PowerShares EM sovereign debt portfolio (PCY).
These two ETFs are not interested in holding paper issued in local currency so should these countries get into trouble like experience sudden capital outflow or get high inflation the debt itself will become questionable.
Now, rally in these ETFs is in its third year, so the question is whether we are close to the top and if so is it worth investing our marginal dollar into these instruments.
Some people, of course, may feel queasy at holding debt paper of unknown governments when they harbor mistrust in their very own, but based on what some economists are saying the rally in these ETFs is not just demand driven but lack of supply and prospects for continuation of such scarcity may drive these shares still higher.
In April 2012, IMF has concluded that the “safe asset demand is expanding at the same time that the universe of what is considered safe is shrinking.”
Of course, the key problem here is what is the definition of “safe” and whether going down the credit ratings food chain is the way to satisfy the safety criteria.
Still, between all of the QEs and cash sloshing the bank reserves, to fixed income demand from insurers and pension funds, “it is clear” the IMF says “that the demand for safe assets is subject to considerable upward pressure.”
Is there enough supply?
Well, as the graph below notes, the AAA-rated paper among the advanced economies has shrunk from 68% to 52% – a $15 trillion contraction in supply – while the lower AA-rated debt in emerging markets went up by 5% obviously an insufficient offset.
Using CDS spreads, IMF projects that by 2016 safe paper could drop additional $9 trillion while private sector “safe” debt is seen, at best, flat.
What happens in the emerging markets?
“In emerging markets, prudent fiscal policies together with ongoing improvement in domestic financial infrastructure—including legal certainty, clearing and settlement systems, and transparent and regular issuance procedures—will support further deepening of local sovereign bond markets. Over the longer run, these improvements will facilitate the use of such securities as safe assets both within their domestic context and possibly in global markets,” say the IMF.
In other words, IMF sees a generally rosy fiscal and regulatory picture for the EMs which, of course, is bullish for their existing dollar-denominated debt paper.
Yet all these countries are loath to issue any new debt a prospect that signals no new significant debt issue by these. In fact, as of 2009, EMs accounted for 40% of the global GDP while their debt accounted for 20% of the advanced markets.
Then again, all of these issues that IMF wrote in April are likely to have been discounted into the price of EMB and PCY and as a result we have an overextended chart above all major moving averages as well as a persistently overbought relative strength measure.
Supposing a resolution to the Eurozone problems, lots of cash will be set to exit these ETFs. Absolute Return Partners Niels Jensen alludes to this powerful set up.
“If structured correctly, a Eurozone exit is not the Armageddon it is so often portrayed to be. When the perma bears realise that, and as they begin to see the benefits bestowed upon the first mover, the mother of all equity bull markets will be unleashed in Europe. As I have frequently pointed out in recent months (see for example here), European equities are extraordinarily attractively priced at levels not experienced since the dark days of the early 1980s. We are just waiting for the catalyst, but remember one thing – banks will not be the place to be,” notes Jensen in his June outlook.