From a sweet spot to a tougher spot
Author: Tristan Sones
March 22, 2019
It’s been a great start to the year for emerging market (EM) debt and high-yield credit, but the sweet spot in conditions that has led to the rally in both fixed income categories may be souring and future gains could be harder to come by over the next few months.
Much of what lies ahead will increasingly depend on the global economy. Over the past few months, investors in riskier pockets of the bond market have largely downplayed the fact that economic data has weakened around the world and instead have chosen to focus on the U.S. Federal Reserve’s decision to not raise interest rates further – at least for the time being.
This makes good sense given that an extended pause by the Fed could be especially beneficial to higher-yielding bonds whose competitive advantage has been slowly eroded by the central bank’s hiking cycle and subsequent rise in government bond yields. In the case of EM debt, moreover, there is the potential added benefit of a prolonged hold on rates leading to less U.S. dollar strength which has been a stubborn headwind for developing countries with current account deficits, in particular.
All of this, however, has largely been priced in and fears about the fallout from a more protracted economic slowdown should start coming to the fore. This, in turn, could leave riskier assets more vulnerable regardless of the direction that global growth eventually takes. Both EM and high-yield debt, for example, could pullback if the economic backdrop continues to falter, while, an improving economy from here may reignite the Fed’s hiking cycle and trim recent gains to much or all of the fixed income market.
“While exposure to high-yield and EM debt remains crucial, stress testing portfolios is increasingly necessary to make sure it is not overly-concentrated in any one fixed income category.”
Needless to say, it’s a tougher spot to be in for investors, but with default rates low and no extreme excesses in the credit market right now, it begs the further question of just how defensive should they get without giving up entirely on the opportunity to generate more yield?
While exposure to high-yield and EM debt remains crucial, stress testing portfolios is increasingly necessary to make sure it is not overly-concentrated in any one fixed income category. This may require some “right-sizing” of positions in higher-yielding areas and giving more consideration to lower-yielding government bonds (i.e. rates) which can provide an important ballast in this type of uncertain environment. Investors should also take advantage of this good credit environment to trim exposure to the cyclical names that might be more susceptible to further economic weakness.
It may be prudent as well to keep credit duration a little shorter and rates duration a little longer, while limiting EM exposure to countries with better or potentially improving fundamentals. This includes those with low refinancing risk, better domestic growth dynamics, a material reform agenda and/or the backstopping and funding of the International Monetary Fund (IMF). For example, Ecuador, the Ukraine and Argentina are all high yield rated countries that have some form of an IMF program in place and a fractional position in their very short-dated debt can provide additional yield with a more favourable risk profile.
If anything, fixed income investors will need to take an approach that is a little more nimble than was required at the beginning of the year. While the recent sweet spot in conditions gave lift to the higher-yielding segments of the market, what lies ahead will be much more discerning.
Tristan Sones is a Vice-President and Portfolio Manager at AGF Investments Inc. He is a regular contributor to AGF Perspectives.
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