With the bond space becoming ever more crowded, investors are being forced to take their hunt for yield increasingly further afield.
As a result, this broadening horizon, along with the benefits of a lower oil price, has put some of the investment spotlight on the emerging market corporate credit spectrum.
However, Trigo Paz, BlackRock’s head of emerging market fixed income, says that because of spread compression the space is under threat of a market reaction to a possible rise in US inflation rates – otherwise known as a ‘taper tantrum’.
“We are prepared for [market reaction] – it is not a low-probability risk,” he expanded. “The level of spread compression in high-quality market names is close to the bottom.
“The first part of this steepening is that there is a lot of compression that can go. The second part is that if we get good US growth or inflation numbers – especially inflation, where the long end of the curve would take a hit. Spreads are at levels where they cannot be compressed any further; spread compression works like a spring – the more you compress it, the more it is charged with energy.”
Circumventing the issue
While the prospect of a taper tantrum may be a concern, Trigo Paz outlined a way in which investors may offset the impact, referring to the pre-emptive method as effectively being “subsidised by the market.”
He explained: “If you hold a high-quality emerging market name that is trading 80 basis points over 30-year US treasuries, what would you prefer – that name, or US treasuries? Always the treasuries.
“If you stick with the plus-80 basis points name it could go to 120 or 140, and, given the duration of the bond, we are talking about a 6% move. Simulations show a seven-and-a-half-year hard currency indexes move of 100 basis points taking value down 7%, which would affect all fixed income assets.
“We would sell that name and eventually it will become cheaper to the value of something that is in the belly of the spread curve and so on. This is what I call being subsidised by the market to improve the quality of our portfolios – not only in emerging markets, but across the board.”
Though Trigo Paz conceded that the solution is a temporary one that will be thrown off when US inflation rates rise, he believes that having the patience to wait until the aftershock has subsided to find quality credit opportunities will serve investors well.
He expanded: “It is a very temporary bridge, and eventually we will either see US rates going higher and people will lose money on improving the quality of their portfolios because US rates have no spread compression. However, you can find quality later on.
“The only positive is that investors are not overweight emerging market. There is no bubble of positioning, so if we get a taper tantrum it should either be short-lived or we would not get the beta levels of 2-1.5 that we have seen previously. The excess positioning is in other asset classes, and this is where we expect things to blow up.
“How do you hedge against that? If you are going to sacrifice 3% yield from US treasuries to get 3.8%, the mathematics do not work, so you need to migrate to the middle of the emerging market curve. While we have sacrificed carry, we are sheltering investments that have performed quite well, and eventually the steepening of the curve will end when Janet Yellen announces a US interest rate rise.”
