INSIGHTS

On June 18, 2018

AAM Viewpoints – Looking to Diversify Income and Risk Away from U.S. High Yield? Emerging Markets Now Provide a Unique Opportunity

Summary

• U.S. high yield corporate debt currently appears long on risk and short on return and is priced for perfection just as creditworthiness sags and leverage skyrockets. The end of a business cycle can be tough on junk debt.


• In contrast, emerging markets (EM) have been beaten up with currency crunches in Argentina and Turkey. Fear of the strong U.S. dollar and interest rate increases have caused investors to sell first and ask questions later. The global economic expansion continues to gain strength, particularly in EM which began its business cycle just two years ago. EM equity and debt now provide compelling yields and valuations.


• U.S. investors can access EM equity and debt through investments in managed products such as ETFs (Exchange-Traded Funds) and Mutual Funds as well as a number of individual EM issues trade on U.S. exchanges in the form of ADRs (American Depository Receipts).

Most folks acknowledge that the United States is in the late innings of the current business cycle and often it can experience cracks in the junk bond markets that show up before cracks in the equity markets. Although we believe the current cycle will extend through at least 2019, as a portfolio manager of corporate credit, we begin to plan for the eventual end of the cycle.

Usually, the end of a business cycle will have some markers that we look for in order to shift the risk profile of our fixed income disciplines. One of those markers is the amount of leverage being extended in the corporate high yield markets versus the potential reward for ownership. That marker is now flashing a bright yellow warning sign and has piqued our interest.

The end of a business cycle generally has markets paying up for less yield in the high yield market. That is a mismatch of risk and reward. The real question is, “If you exit the U.S. high yield market, then where can you replace the yield?” We think advisors should look at EM debt and equity.

Many advisors are looking for high yielding alternatives to the ultra-levered U.S. high yield markets. With yields in that market now down in the 5% area, we believe there is reason to be wary of the higher risks in the U.S. high yield corporate markets. Recent turmoil in Argentina and Turkey has caused other emerging market debt instruments to sag, pushing up the yields to levels not seen in years. Our opinion is that there is no contagion in EM debt and investors should use this opportunity to potentially shift from U.S. high yield to EM debt. We believe that the lower leverage and growth outlook for the markets are superior to the United States and that the current dislocation presents a positive opportunity.

The global debt markets have indeed flourished over the past decade due to record-low interest rates. With money nearly free (and in Europe it was free), it comes as no surprise the amount of corporate and sovereign debt has exploded. However, given that EM countries spent many of those years in an elongated recession, the leverage was far less pronounced. Note the chart below showing that the build in debt (both sovereign and corporate) to GDP over the past decade has been focused in Developed Markets; EM have actually trailed in their expansion of leverage. With global inflation now rising, the cost of the debt to the issuers will rise as well putting the pinch on their ability to pay.

My work with our Chief Investment Strategist, Matt Lloyd, tells a troubling story for U.S. high yield. Matt has contributed some observations on the state of the junk markets that are indeed eye opening. Matt annotates the following graph showing a red bracket for those countries in trouble, a yellow for those countries that investors should pay caution to and green for those countries with acceptable debt-to-GDP levels. Note the green box is populated with EM names rather than developed countries.

In addition to the massive build up in corporate debt, the amount of leverage on new issue loans has been escalating. Higher leverage means higher vulnerability to the issuer if the economy slows or a recession occurs. The chart at left indicates how leverage dropped in the 2008/2009 crises but has been steadily coming back ever since.

Along with our cautious view of U.S. high yield, we note that many bonds being bought in the market today are starkly lite on protective covenants. The Corporate Bond chart below shows the percentage of Covenant-Lite loans sold. Covenants are provisions in the bond indenture that are designed to protect bondholders from certain events that happen to the issuer. These covenants generally are required before investors will buy debt. The last innings of an economic expansion can see these “protective covenants” disappear as investors seek higher yields and see current economic conditions as good.

What do we see? We see credit underwriting slipping to lows not seen in this century and risk being elevated to the highest levels. Just as a lack of proper underwriting on mortgages wrecked the markets in 2008, we think a lack of underwriting in the corporate bond market might be a cause of the next collapse.

Many investors believe that EM debt and equity will suffer as the Federal Reserve (Fed) raises interest rates. They believe that since much of EM debt is denominated in U.S. dollars and a stronger dollar will make repayment of those obligations much more expensive to the issuer, which is why they believe that the embedded currency risks make EM securities too risky. The recent weakness in Argentina and Turkey currency markets emboldens their argument.

We see a different story. We see EM in their second year of economic recovery. The Russia, India, Asia and Latin America economies are generally strengthening with many of these markets having a high correlation to petroleum and raw materials. Commodity markets have rebounded significantly with global growth and we believe that the simmering inflation pressures will continue to pressure prices higher. While it is true that some EM debt is denominated in U.S. dollars, it is also true that many issuers hedge out the currency risk and those markets are much less bothered by swings in the dollar than they were historically. The rise in the value of the dollar has put the currency in the same place as it was roughly a year ago.

Thus, our position is that EM debt and equities present a significant value to investors who are on a quest for yield. We believe that higher yields and lower leverage levels provide a strong risk/reward opportunity. With yields in the 6-8% for EM debt and equities, we think these areas should be considered as an alternative to U.S. high yield.

U.S. investors can purchase EM equity and debt in a number of managed and unmanaged ways, including many mutual funds and ETFs that invest in EM stocks and bonds, and exchanged-traded closed-end funds that specialize in EM.

Our conclusion is that we have begun to see very real warning signs in the U.S. high yield corporate bond market. Excessive leverage, combined with relaxed covenant protection, coupled with very low yields makes this market hazardous to invest in, in our opinion. Emerging market equity and debt, however, are much less levered and have the potential to provide higher yields. Emerging markets had their first year of recovery in 2017 and we expect that recovery to last for a number of years. We think the short-term headwinds provided by weakness in Argentina and Turkey will pass and that valuations will improve. In short, we believe this is a buying opportunity for Emerging markets.

CRN: 2018-0604-6692R

AAM sponsors a high yield EM dividend fund under the symbol EEMD. This is neither a recommendation to buy or sell this fund. All investors should read the fund prospectus and understand the risks of investment.