By Rafael Biosse Duplan
After a decade of decoupling positively from developed market (DM) credits, emerging market (EM) credits have now started underperforming. There are good and bad reasons for this development:
1. EM growth has slowed down, at a time where DM growth prospects, especially in the US, UK and Japan are improving: this in turn makes EM credit less appealing.
2. Significantly, whilst the growth differential remains in favour of EMs, the spread is narrowing. The EM growth model, based on rapid credit expansion, could therefore be running out of steam.
3. Capital flows to EMs have weakened as funding rates threaten to go higher as a result of Fed tapering. This will make refinancing rates more expensive for borrowers and will create sizeable supply in the new issue market.
4. Social unrest has agitated large EM economies, especially Turkey, South Africa and Brazil, highlighting concerns about slowing growth and emphasizing the need for a political appraisal of EM economies.
5. Retail flow of funds into EM credit have ground to a halt. However, these flows are hardly an indication of either future performance, or a leading indicator of strategic institutional flows based on longer cycles.
6. EM assets have had a bad year, re-enforcing the negative perception of the asset class. Although one needs to differentiate the credit returns, still decent in 2013 from the highly negative duration returns over the same period.
The answer of the unlevered community (traditional asset managers) to these challenges has been overwhelmingly to reduce duration, now turned their worst enemy, and compromise the credit quality and the liquidity of their portfolio by over allocating to high yield and frontier markets, in order to gain extra carry. This, in turn, is largely responsible for what we believe are stretched valuations in the EM high yield corporate market and undervaluation of the long-end investment grade bonds across the sovereign, quasi-sovereign, and corporate bond markets.
Looking to 2014, we believe that the performance of EM credit will primarily be a function of how well large EM economies, China in particular, will be able to maintain their growth model in absence of further credit stimulus.
However, only an EM islomaniac would deny that the global credit environment and EM in particular, will also be largely dependent of the Fed actions, and where long-dated US Treasuries finally settle.
We believe that this environment offers four major sources of alpha:
1. A very active primary market will offer opportunities to the discerning credit investor.
2. EM high yield corporate bonds are too expensive and will re-price in weak markets. Would you be wrong in shorting them? Abundant supply will keep yields, already at their lows, from tightening further.
3. Long-duration investment grade assets will oversell periodically; these will offer compelling value and convexity to those who can hedge out duration and short dated credit risk. This will be particularly the case for sovereign bonds, which will have very limited supply in 2014.
4. Higher funding rates, over-levered balance sheets and slowing growth will precipitate some reckless sovereign and corporate borrowers into default, offering both idiosyncratic shorting and recovery opportunities.
Geographically speaking Asia, with the most levered balance-sheets and a stretched banking sector, will be the largest issuer across the rating spectrum, providing long and short opportunities. Europe, the region of the world with the slower recovery and already low yields, will offer value only in long duration and orphaned assets. Finally, Latin America has outstanding sovereign trading markets in Venezuela and Argentina and is fast developing a market for high yield fallen corporate angels, which will be source of both strategic and tactical opportunities.
Rafael Biosse Duplan is portfolio manager, Finisterre Capital Credit Fund
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