Investors are not being compensated for the credit and illiquidity risk they are taking when investing in local currency emerging market debt, according to M&G’s global bond team.
Manager Mike Riddell (pictured) sits on the management team for the M&G Global Macro Bond A USD AccM&G Global Macro Bond fund alongside Jim Leaviss. He said the team is currently shorting local currency emerging market debt, where they view credit spreads as far too tight and argue that investors are not being compensated for potential illiquidity – particularly in the event of a market shock.
The team is holding credit default swaps against Brazilian, Russian, Turkish, Indonesian and South African debt.
The team’s call on emerging market debt is also underpinned by a view the sector will be vulnerable if the dollar appreciates. This is their central scenario and is linked to a bullish view of the US economy.
As the Republicans and Democrats seek to flesh out a deal ahead of the fiscal cliff at the beginning of next year, Riddell anticipates a solution will be reached and expects GDP could be roughly around 1% lower as a result, not as great as the 4% drop that has been estimated.
‘The market is obsessed with the fiscal cliff, but we think a much bigger driver longer term is the very strong outlook for the US housing market,’ he said. ‘We think the US housing market could easily grow between 5% and 10% a year for the next two years. So the US economy looks very strong.
‘At the same time you have got the Federal Reserve starting to move away from saying we won’t hike rates until mid-2015. They are now saying “when unemployment reaches x%” or “inflation is y%” or “nominal growth is...”. They have not said what the variables are, but they are focusing on a moving target rather than a fixed time.
‘What does this mean for our fund? If the US is increasing interest rates, that will be very good for the US dollar and emerging market currencies normally do the opposite to the US dollar. It is also bad for Treasuries,’ he said.
It is for this reason the team also has a short position on US Treasuries. ‘Emerging market debt valuations look terrible. We think the US economy looks strong though and the Federal Reserve will be increasing interest rates sooner and more than the market expects,’ he added.
Profiting from OMT
The team have also profited from greater visibility in the eurozone, following European Central Bank president Mario Draghi’s outright monetary transactions (OMT) announcement in September, which helped to stabilise yields on peripheral debt.
The managers bought Italian government bonds in July, having not had exposure to the region since buying in January and selling in February and March following the long-term refinancing operatons announcement. Likewise the fund has built up an allocation towards the euro, where they now have a 27% exposure – from zero earlier in the year.
The move into peripheral debt has helped to power the performance of the £258 million fund. Over the 12 months to the end of November, it has returned 8.9% while the Citigroup WGBI US dollar-denominated index rose 1.6%. The fund yields around 1.2%.
‘Buying into risky assets in July was a good thing. Over the last 12 months our timing for buying and selling peripheries was good,’ Riddell said. Nonetheless, he added being negative on emerging debt too early and being short duration had proved a dampener on performance.
Looking ahead, he highlights inflation as one of the most significant headwinds and a potential downside surprise over the next five years. As a result, around 20% of the fund is in global inflation-linked bonds.
‘We prefer index-linked over conventional gilts. Inflation-linked gilts are pricing in a 2% inflation rate over the next five years and we think there are big risks inflation will be higher than that over the next five years,’ he said.
Over the past month the team has been reducing the credit risk in the fund by taking profits on global investment grade and high yield positions, and making the portfolio slightly more defensive.
‘I think valuations have been distorted by central bank liquidity measures. Our view is the US market will be stronger than people think and the Federal Reserve will increase rates by more than people think,’ said Riddell.
‘By definition that liquidity that has been driving markets over the past two years has made this huge rally and that liquidity will cease to be there – and that makes us a bit more worried about risky assets generally,’ he added.