Beware the crowded yield trade
In the second of a two-part series exploring the flight to safety versus the quest for yield in fixed income, we look at how fund managers are scouring riskier parts of the bond market for returns.
These are strange days for the bond markets. Global sovereign debt yields $500 billion less annually than five years ago, according to Fitch Ratings – good news for governments, perhaps, but bad news for investors. Meanwhile, corporate bond yields have also plunged at a time when the European Central Bank (ECB) and its peers in the UK and Japan are implementing credit-easing programmes to kick-start economic growth.
With yields scarce – and risks abundant – investors are short of options. Rather than vacate the asset class altogether, however, many fund managers are exploring new ways to eke more yield from their portfolios. While government bond investors are extending the maturities of their holdings, (see part one), corporate bond investors are taking on more credit risk. They are moving into high-yield and emerging-market debt, as well as more esoteric instruments such as hybrid bonds and volatility trades.
While these strategies can deliver results, there are signs credit investors are increasingly chasing returns indiscriminately, without paying enough attention to the underlying risks. Indeed, the current situation echoes the peaks of previous credit cycles, where low yields in ‘safe’ assets led to capital flowing into ever-riskier debt instruments, fostering dangerous asset bubbles.
Are we seeing history repeat itself? And how might investors position themselves to gain access to yield while avoiding the risk of a sudden market correction?
Emerging markets have been among the chief beneficiaries of the hunt for yield in fixed income in 2016. The average yield on debt issued by emerging-market governments this year is 5.4 per cent as of September 15, 2016 down from 6.7 per cent at the beginning of the year. Emerging-market debt funds received record inflows of $4.9 billion in the week ending July 20, 2016.
In certain respects, this trend is reminiscent of the years between 2009 and 2013, when emerging markets received almost half of all global capital flows, according to data from the Bank for International Settlements (BIS). When the Federal Reserve indicated it would tighten policy and wind down its bond-buying programme in the summer of 2013, emerging markets suffered big outflows in what became known as the ‘taper tantrum’.
Emerging-market corporate bonds actually outperformed emerging-market sovereign bonds during the turmoil, partly because the average duration on this type of debt was shorter. But a repeat of the ‘taper tantrum’ would likely be more damaging to emerging-market companies, because the amount of emerging-market corporate bonds maturing between 2016 and 2018 is set to rise 40 per cent on the previous three years. If liquidity becomes constrained, it will be more expensive for companies to refinance their debts, putting them under increasing pressure.
But while the large cash inflows to emerging-market debt may suggest a bubble risk, examining the composition of those flows reveals a more nuanced picture. After the financial crisis, the appetite for emerging-market debt was largely driven by retail investors, but now it is dominated by institutions such as insurance companies, sovereign wealth funds and pension funds, which tend to invest over the longer-term and may be less influenced by short-term bouts of market volatility.
“Retail investors left the asset class in their droves after the taper tantrum and that money has only just started to come back,” says Aaron Grehan, Senior Portfolio Manager in Aviva Investors’ Emerging Market Debt team. “Recent flows have been driven by institutional investors, which are allocating more of their portfolios to emerging markets because they are attracted by longer-term drivers of economies, such as increased consumer spending and favourable demographics.”
According to research from the International Monetary Fund (IMF), capital flows to emerging markets between 2009 and 2013 far exceeded what might have been expected based on fundamental factors; the ‘overflow’ totalled some $500 billion. By contrast, recent demand appears to be supported by strengthening emerging-market fundamentals: commodities prices have risen and stabilised, while fears of a sharp slowdown in the Chinese economy have receded. More importantly, perhaps, the IMF expects the pace of GDP growth in emerging markets to increase every year for the next five years as developed economies stagnate.
Nevertheless, there are signs that the hunt for yield has begun to create distortions at the riskier fringes of emerging credit markets. The average yield on sub-investment grade emerging-market debt has plunged to a two-year low of 7.3 per cent, even though default rates are at a six-year high of four per cent, according to Bank of America Merrill Lynch data.
Grehan says emerging-market debt still offers value – especially in local currencies – but he is keeping an eye on the risk that the strong appetite for the asset class could distort valuations. “At the moment we’re not concerned that the value has eroded. But if strong capital inflows continue, we could see indiscriminate buying return to the asset class. We’re wary of that.”
One market that looks particularly overpriced at current levels is Europe, where the European Central Bank’s corporate sector purchase programme (CSPP), introduced on June 8, has contributed to a plunge in yields. A striking example came on September 6, when investors started paying two big companies for the privilege of lending them money: German consumer goods company Henkel and French pharmaceutical producer Sanofi both sold debt at a yield of minus 0.05 per cent.
As central bank intervention sends corporate bond yields to new depths, investors are looking to riskier parts of the market for returns – and this at a time when European companies look weaker. Sluggish growth and vulnerabilities in the continent’s banking sector – not to mention heightened political risk in the wake of the UK’s vote to leave the European Union – all present significant threats to credit markets.
“Central banks’ bond-buying programmes have contributed to a herd mentality in bonds. Investors are hunting yields in a complacent way, and not paying proper attention to the underlying risks,” says Chris Higham, Head of Credit Multi-Strategy Fixed Income at Aviva Investors. “Slow economic growth – and a potential recession in the UK following the Brexit vote – means there are likely to be more corporate defaults in Europe. But the technical indicators remain strong because of central bank policies. This divergence between technical and fundamentals is not sustainable.”
As in the government bond markets, credit investors are taking on duration risk; buying longer-dated debt because it tends to offer higher yields than shorter-maturity bonds from the same issuer. In August, telecommunications firm Vodafone was able to sell a 33-year sterling bond at a yield of 3.4 per cent – the lowest-ever recorded on a sterling bond of more than 30 years from a triple-B-rated issuer.
But credit investors are also moving down the rating spectrum. They are looking at securities that combine equity and debt-like characteristics, such as contingent convertible (or ‘coco’) bonds issued by financial institutions. Designed in the aftermath of the financial crisis to transfer bank risk from taxpayers to investors, these hybrid instruments offer relatively high yields but convert to equity – or absorb losses – when the issuer’s capital ratio falls below a specified amount, leaving investors exposed.
“Investors need to keep an eye on corporate hybrid issuance,” says James Vokins, Senior Portfolio Manager, Multi-Strategy Fixed Income at Aviva Investors. “Companies are issuing debt that from a fixed-income perspective looks like a debt-like instrument, while credit ratings and accounting principles treat it partly like equity. If you’re going to invest in those bonds, you should be aware of the risks.”
The hazards involved in the illiquid coco bond market were illustrated in February. Yields on Deutsche Bank’s coco bonds spiralled from 7.5 per cent to 13 per cent over the space of a month after its capital ratio fell below the defined threshold (although it later made the interest payments on the bonds). The large price swings on these securities suggested they had been targeted by pro-cyclical investors who dumped them in a hurry when the risks became apparent, demonstrating how the rapid departure of ‘hot’ money from an asset class can generate damaging volatility.
Some investors, however, believe that volatility will remain low – and have spotted an opportunity to profit from that prediction. Known as ‘selling vol’, this strategy involves selling options that pay out if the price of the underlying asset moves by a defined amount. It’s not a new approach by any means, but the range of participants in such trades is expanding as the hunt for yield pushes investors into unfamiliar territory.
Taiwanese insurance companies, which were recently freed to invest in overseas assets by the domestic regulator, are among the institutions that have started deploying this strategy, which used to be the preserve of big banks and hedge funds. Facing average weighted liability costs of 3.8 per cent – far higher than their average investment yield of 2.8 per cent – these institutions are under pressure to increase returns, and have turned to selling volatility on long-dated corporate bonds as a way of boosting profits without taking on more credit risk. But it’s a dangerous game.
“The cheapest and easiest way to get yield at the moment is to sell volatility. But the new entrants to this market are inexperienced and it can be a dangerous strategy – you’re effectively picking up pennies in front of steamrollers. If the cycle turns and yields suddenly rise, we could see a pretty explosive correction in the marketplace,” says James McAlevey, Senior Fund Manager, Fixed Income at Aviva Investors.
Such investment behaviour demonstrates how central bank policies are creating distortions – and may even be contributing to instability in the financial markets. “Because there’s no yield in bonds, investors are reaching into new, potentially risky areas. That’s calling into question the wisdom of central bank policies. If US Treasuries yielded three per cent, do you think investors would be selling volatility on long-dated bank credit? Probably not,” says McAlevey.
If central banks increased interest rates to ‘normal’ levels, the mania for duration risk, hybrid debt and volatility trades would cool, bringing normality to a distorted market. Then again, such a policy would also leave those investors who have piled into these strategies vulnerable to losses. Such is the tightrope central bankers must walk.
The possibility that central banks might change tack spooked markets on September 9, amid widespread rumours the Bank of Japan would taper its purchases of longer-dated corporate bonds. The global 10-year US Treasury bond yield rose by eight basis points; not an extreme move, but evidence that sentiment remains fragile.
History doesn’t repeat – but it rhymes
Given the uncertain market backdrop – and the difficulties of second-guessing central bank policy decisions – Grehan believes it is increasingly important for fund managers to pay attention to both fundamental and technical factors to insulate portfolios from the negative impacts of volatile capital flows. “What you don’t want to own is a poor credit in an expensive market. If the market turns you’re going to get hit on all counts. If you own a resilient, fundamentally-supported credit then you can be comfortable that your downside is going to be limited, even if the wider market is overpriced.”
But return-generating opportunities are also arising. McAlevey points out that fund managers could take the other end of insurers’ volatility trades, a strategy that would deliver profits if the market turns and yields rise. Investors can also boost their returns by keeping an eye on policy decisions and anticipating where capital will flow next. Holders of US bonds, for example, have realised capital gains as new investors moved into the market in search of relatively higher yields after the ECB introduced the CSPP. The average yield on sub-investment grade debt in the US fell from a high of 9.4 per cent in February to just under six percent in early September.
“You need to look at which markets will be the secondary derivative benefactors of policy decisions,” says Vokins. “It stands to reason that if central banks are buying corporate bonds in Europe then yields will fall in the US too, because investors will cross the Atlantic in search of yield.”
The clamour for US high-yield bonds has persisted despite relatively high default rates, which hit a six-year high of 5.1 per cent in the second quarter 2016, up from 4.1 per cent in the first quarter. The US high-yield sector was one of the worst hit during the last cycle, when the precipitous fall in oil prices in 2014 forced many energy issuers into defaults. But current defaults remain below the market’s historical average default rate of 5.4 per cent, suggesting there remains value in US high yield for the time being.
Problems may be mounting in the ostensibly safer environs of US investment-grade debt, however. According to research from Morgan Stanley, these companies are increasing leverage even as earnings stagnate: US investment-grade firms carry debt loads that amount to 2.5 times their collective earnings, and this figure has climbed for the last five consecutive quarters. (By comparison, in 2010, as the US economy began to recover from the financial crisis, the ratio was 1.7 times.)
Despite these escalating debt levels, the average yield on US investment-grade debt had fallen to 2.8 per cent as of September 12, down from a high of 3.5 per cent in February 2016. This illustrates how the historical correlation between leverage and credit spreads has broken down amid the hunt for yield.
“You need to look at where the reach for yield has been occurring and the factors that may change the balance of supply and demand,” says McAlevey. “In markets that have a high percentage of retail ownership compared with historical patterns, a catalyst could change the environment very quickly. You saw that happen in emerging markets during the ‘taper tantrum,’ and in US high yield after the oil price collapse. The catalyst is likely to be different next time, and may occur in a different area of the market. But the result will be the same.”
As central bank policies distort markets and cash flows toward riskier assets, credit investors would do well to keep in mind a piece of wisdom attributed to Mark Twain: History doesn’t repeat itself – but it does rhyme.
 JPMorgan Chase & Co.
 ‘International Capital Flows and Vulnerabilities in Emerging Economies,’ Bank for International Settlements, August 2016
 The IMF factored GDP growth, domestic interest rates, and exchange rate misalignments into its analysis of fundamental strengths and compared historical patterns of demand for emerging-market debt. ‘Emerging Market Volatility: Lessons from the Taper Tantrum,’ IMF research note, September 2014
 S&P U.S. Issued High-Yield Corporate Bond Index
 ‘Leverage Soars to New Heights as Corporate Bond Deluge Rolls On,' Bloomberg, September 2016
 S&P US Issued Investment Grade Corporate Bond Index
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