Where’s the Yield?  

The article compares valuations in the US and emerging market high yield debt.

After a long rally in both emerging market as well as US high yield debt, we compare valuations in both markets. We find that some emerging market debt offer better value for investors willing to take long duration risk. Investors looking for shorter maturities will find US high yield debt more attractive.

Emerging Markets Offers Value in Long Duration

Emerging market debt has enjoyed one of its longest rallies, as spreads tightened due to a coincidence of favourable factors — improved economic prospects in Latin America, especially Brazil, ample global liquidity and increasing risk appetite. We have argued that although spreads against US Treasuries are almost at their lowest level in a decade, this level can be justified by the significant improvement in credit quality (see Chart 1). About a third of the most commonly used emerging market index (‘EMBI Global’) is now comprised of investment grade credits.

While the case for improved credit quality justifies reduced spreads, the case for emerging market debt is not always obvious compared to US high yield debt. Chart 2 compares the yield curves for some emerging markets to B-rated US companies. Although these countries clearly compare well at the middle to long end of the yield curve, short-dated paper appears over-priced. A similar picture appears with respect to rated credits such as Colombia and the Philippines, as well as BBB-rated Mexico.

At current levels, emerging market debt offers value in those cases where economic fundamentals appear to be improving sufficiently to justify duration risk at the long-end of the yield curve. We believe such a case is compelling in some, but not all, countries.

In Brazil and Colombia the case is clear, as economic policies are on a track, it should lead to an improvement in credit quality. A bet on Uruguay is more speculative, as it depends not only on economic policies adopted by the Uruguayan authorities, but also on developments in neighbouring Argentina. In the Philippines and Turkey the case is less obvious. In the former, we think that yields that are below Colombia’s are not sufficient compensation for risks in a country with a poor track record of economic policy implementation and presidential elections in May of 2004.

In Turkey, valuations are more complicated. By taking a long-term view, investors are implicitly betting on progress on three fronts: economic growth, political reform and a sustainable improvement in debt dynamics. Economic growth has been better than expected while political reform has been encouraging. But a sustainable improvement in debt dynamics has not been fully achieved. Declining real interest rates are a clear signal of improvement, but the government has shown an inconsistent record in maintaining fiscal discipline.

Mexico also offers value in long duration when compared to BBB corporate bonds, while Russian debt trades at very similar yields. In the case of Russia, which is not yet investment grade, current valuations need to be validated by a rating upgrade which is unlikely to happen until sometime next year.

US High Yield Debt is Still Attractive

Global High Yield bonds too rallied strongly since autumn 2002, posting total returns of approximately 30% due to several favourable factors, mainly: improvements in the economic environment, particularly in the US, continued balance sheet repair and thus enhancements in credit quality, the expectation that interest rates will remain low for an extended period of time and the continued search for yield enhancement by investors.

From a valuation perspective, US High Yield may seem slightly dear at first glance. Current spreads already trade at their long-term average (around 550 basis points). However, credit fundamentals are improving at a rather fast pace. Default rates for high yield bond issuers are now down to 5.8% globally and in the US the rate dropped to 5.4%, the lowest level since summer 2000 and more than five percentage points below August 2002.

Furthermore, the spread between USD High Yield and US Treasuries is still approximately 300 basis points above the lows that were observed between 1992 and 1995 when default rates had reached their lows in the past business cycle. True, current credit quality in the USD High Yield market is still less compelling than in the mid-nineties, but with a further pick up in economic activity, a US Federal Reserve on hold for the time being and more de-leveraging ahead, future default rates can drop to the levels which we saw in the beginning of the past upswing. Technical factors are also supportive for US High Yield: supply has slowed recently and year-to-date inflows into high-yield mutual funds remain well ahead of inflows for the same period last year.

So, we feel that further falling default rates will foster another extension of the High Yield compression trade. We believe that this horse has not yet run its race and we expect USD High Yield bonds to provide investors with at least a 9% annual return over the next 12 months which is slightly above the average. For this reason, we assess USD High Yield as moderately attractive.

Conclusion

US high yield debt and emerging market debt are not strictly comparable. The differences in yields shown above can in part be explained by the higher liquidity and diversification of the high yield market, compared to the individual countries we have chosen. At the same time, the low yields in shorter maturities of emerging markets could be explained by investor’s perceptions of low immediate risks in some emerging markets.

Individual investors need to balance the attractive yields that emerging markets and US High Yield debt offer, with the risks inherent to maintaining an exposure to bonds during an economic recovery. Investors seeking to maintain short-dated duration will find better value in US High Yield rather than emerging market debt. In cases where economic policies will likely lead to a ratings upgrade, we believe that returns will continue to be attractive. Given current valuations, we believe investors seeking only short-dated investments will find better value in the USD High Yield market rather than emerging markets.

Oussama Himani Olaf Liedtke
UBS Wealth Management
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