Why EM bonds are a bridge too far

We are already seeing this sentiment in play with EM bond issuances but we ultimately believe that this trend will put more pressure on an overleveraged system that is tired and ready to collapse.

The Philippines issued the first EM bond of the year. The country raised $1.5 billion in 10-year notes offering a yield of 3.782%, which corresponds to 110 basis points over US Treasuries. The bond was announced with an initial pricing of 130bps over Treasuries, that investors were 20 bps more eager than expected.

This is a clear example that shows the degree to which investors are relying on central banks. On one side, sentiment clearly improved because of the Fed’s dovishness; on the other, after a Philippines’ CPI reading that pointed to lower inflation expectations, investors seemed to conclude that with a slowing global economy, the country’s central bank will not hike interest rates for a while, and bonds will benefit.

It is alarming to see a market so dependent on central bank support while the economic and political outlooks of these countries remain fragile.

The Philippines was not the only country to issue bonds in the first weeks of this month. Saudi Arabia and Turkey also took advantage of the Fed-fuelled positive sentiment to issue bonds.

Despite wariness towards Saudi Arabia after the killing of journalist Jamal Khashoggi, Riyadh was able to tap the market with $7.5bn of 10-year and 31-year notes. The bond attracted demand amounting to $27.5bn, causing the price to rise compared to initial guidance.
Troubled Turkey also opened 2019 by issuing its longest-dated dollar bond in almost a year, selling $2bn in 10-years due due April 2029. Similarly, high investor demand pushed the initial public offering of 7.875% down to an initial yield of 7.68%.

These countries set a dangerous precedent for other EM countries inclined to test the market. As equity market stabilises and Fed tightening policies grind to an apparent halt, other EM countries are lining up to get a piece of the pie; there are already rumours that Ivory Coast is planning to sell $1bn in Eurobonds. 

This can only mean one thing: EMs are getting more and more leveraged and exposed to fluctuating movements of hard currencies such as the euro and the US dollar.

Assuming that a dovish Fed is the fix to a slowing economy, an overleveraged financial system and political uncertainty is the biggest bet available to investors right now, and it they are lining up to take it. Our belief, however, is that a dovish Fed is no cause for celebration, but rather a cause of concern! Just last year, the Fed maintained a positive view of the economy, hiking interest rates because it thought that there was a basis for continued stability. Now that this is lacking, investors should be bearish, not bullish, especially when it is clear that if recession comes, it might only be the US that has the tools necessary to stimulate the economy.

This doesn’t mean that investors should dump EM bonds and fly to safety. In fact, history teaches us that opportunities remain present even during moments of distress. Rushing to secure that little fragment of extra yield, however, doesn’t make sense. It is important to be rational when making investment decisions and understand risk fully.

The rush for yield in the bonds discussed above is irrational. First, we are talking about sovereigns. Although sovereigns are perceived to be safer than corporates, it is important to note that while corporates default because they cannot continue their ongoing operations, the majority of the time sovereigns default because they don’t want to repay investors due to political reasons. Today, when political uncertainties are high and populist heads of state lead a considerable chunk of the world’s nations, I believe there is reason for extra caution.

Erdogan and Duterte don’t appear to me like leaders looking to move their countries in the direction favoured by international investors. It is likely that as soon as economic issues arise, they will not hesitate to take unconventional measures – as they have already demonstrated. 

I don’t think getting paid 3.782% for 10 years (US718286CG02) by the Philippines’ government, which corresponds to a pick up of 110 bps over US Treasuries, adequately compensates me for the risk I am taking. 

At this point, I prefer to look at US corporates, which at the moment are easily offering 100 bps over Treasuries in the investment grade space. Last week, we made the case for Ford, which is rated BBB- and offers approximately 5% in yield for a two-year maturity, which corresponds to 200 bps over Treasuries.

The same is true for countries now led by populists, such as Mexico and Brazil. It seems, for instrance, that Bolsonaro and AMLO are being received fairly well by financial markets; Bolsonaro appears to be preparing the much-awaited pension reform, while AMLO is making investors happy by cutting IPO proceed taxes to spur growth in the financial system. All seems well enough… but are we ready to enter into a nine-year USD bond for Mexico (US91087BAE02) that pays a little above 4% in yield? Remembering that during the presidential campaign, AMLO was vocal about making Mexico energy independent in a move would clash with the US’ long-term goals? A 4% yield is not enough to compensate such a political risk, in my view.

The same think can be said for Brazil. Bolsonaro has a history of a far-right, pro-dictatorship and racist statements. Does a yield of 4.8% for the Brazilian 9-year bond in USD (US105756BZ27) deal adequately with the political risks he poses? We don’t think so.

Although EM assets were repriced in 2018, they remain expensive. Moving blindly into EMs when there are endless options available closer to home seems like a risk worth avoiding.