Fixed Income Boutique
The current crisis is as unprecedented as are the reactions to it. Fund flows in emerging market hard currencies have nose-dived into negative territory for the first time in five years. Even in 2018, when central banks started to tighten monetary policy, flows were positive. Therefore, the quite substantial outflows seen in the turbulent first quarter this year should not be underestimated. However, the G20 central banks’ massive intervention has had a quite positive impact on the markets. The estimated USD 4.5 trillion expansion of their balance sheets within just three months flooded the system with liquidity. In the 2008 global financial crisis, they threw in such an amount of stimulus over a period of three years. Obviously, at that time the problem was due to a rotten banking sector and particularly difficult to resolve, whereas this time, we have witnessed a liquidity shock. Let us hope that aggressive monetary and fiscal policy can address the damages of a simultaneous supply and demand shock across the globe.
Since the strong sell-off and price erosion the pandemic panic caused in emerging market corporate bonds in March, their spreads have kept tightening across the rating segments, with high yield outperforming investment grade recently. However, they stay elevated relative to the low yields of US treasuries, while high-yield emerging market corporate bonds offer higher spreads than their US and European counterparts. In our view, emerging market corporate bond spreads currently are an attractive option for return-oriented investors.
We are convinced that investment success with emerging market corporate bonds requires both spread optimization and spread diversification when building a portfolio. Spread optimization is key because higher spreads feed into higher yield, and higher yield usually boosts performance over time – and this for just a slightly lower average rating. Spread diversification is increasingly important. In a low-rate environment, investors seek spread to boost performance. However, spread markets are generally highly correlated – and indeed with equity markets. Therefore, investors should seek diversification, which we have found to exist in corporate event-driven situations.
Our investment process starts with top-down analysis to filter interesting strategic themes and to compare the countries, sectors, ratings, as well as relative values. Then, in our bottom-up analysis, we identify juicy value trades, find the right segment allocation, and pick out promising event-driven or special situations. Diversification and risk management sit in the heart of the process. In our Emerging Markets Corporate Bonds portfolio, we typically assign 70-80% of assets to spread optimization with a realized extra spread of 200-500 basis points above its benchmark over time for a slightly lower average rating of BB-/BB versus BBB- (subject to change without notice).
To achieve this, we apply our contrarian & value approach, based on bottom-up rich/cheap and lead/lag analyses with a focus on underperforming cheaper bonds, which pay somewhat higher spreads because the consensus loves them less. We assign the remaining 20-30% of portfolio assets to spread diversification in search of recurring alpha with low correlation to other spread markets by applying event-driven strategies and focusing on special situations, which may incur a stronger price correction if something unexpected happens.
From our standpoint, the importance of event-driven situations is growing now, because central bank action has solved the liquidity problem, but not the solvency problem of many companies left with destroyed business models. Airlines, for example, will have to realign and probably shrink their business. This need for restructuring is likely to open up many opportunities in the event-driven space, even if it may take some time, depending on the case.
Given the prevailing uncertainty and poor fundamentals, our current focus is more on sizing of positions in order to enhance diversification. Therefore, our current positions are less concentrated than is usually the case. For the time being, we have only a handful of names whose exposure is above 2%. Our largest two positions were among the best performers in the rebound.
Explaining spread optimization works best by specific value-oriented trades. Three of our major positions in this space are:
Indiscriminate sell-offs like the one we saw in March usually offer unmatched opportunities. This is why it is so important not to be paralyzed by a crisis but remain active. Our contrarian approach allowed for extensive trading. Maintaining higher liquidity gave us flexibility when the situation started to improve – an advantage over peers that have mostly lagged in terms of recent performance. On the one hand, we increased our exposures to Mexico, Qatar, South Africa, Colombia and Sri Lanka, where we were able to make multiple profitable trades. On the other hand, we decreased exposures to Russia, Indonesia, Turkey, Ukraine and Argentina, as we saw either outperformance or the opportunity set was no longer interesting from our standpoint.
The essence of our strategy is to benefit from behavioral and regulatory biases. We seek to exploit mispricing through value- and event-driven strategies. For example, the Covid-19 pandemic plus the simultaneous oil price war between Russia and Saudi-Arabia affected certain issuers in the investment-grade segment to such an extent that important rating agencies downgraded their credit ratings to high yield. The chemicals and energy company Sasol in South Africa was among them. Such events may force investors to sell due to liquidity needs or strategy constraints, triggering nervousness and an overreaction in the market, which usually sends the bond price disproportionately downwards. We try to seize such opportunities by entering into the trade when we observe forced sellers.
In a low-rate environment, spreads gain in importance for income- and return-oriented investors. Currently, emerging market corporate bonds offer attractive spreads compared to other markets. Nevertheless, at some point, rates will rise again. Therefore, we keep duration rather short to keep interest-rate sensitivity low.
Diversification and risk management continue to build the core of our investment process, because emerging markets may be volatile given the current uncertainty. Even though liquidity provision by central banks supports the bond markets, it has not eliminated the solvency problem some companies are facing. Therefore, credit differentiation becomes increasingly crucial.
In addition, the medical situation around the pandemic might deteriorate. The recovery of the economic fundamentals might lag. Geopolitically, the tensions between the US and China, the forthcoming US elections, and social unrest due to economic lockdowns might have their impacts.
Nevertheless, analysis of financial market history showed that such an excessive spread widening as the one seen in the aftermath of the pandemic shock is rare. At present, emerging markets see multiple mispriced corporate bonds, which offer a broad opportunity set for alpha generation through skilled active management. We are ready to seize them.