By Marco Santamaria
We believe investors should be thinking about emerging-market debt in terms of credit quality buckets (investment grade or high yield) rather than sectors (sovereign or corporate). For some types of investor, pure high-yield strategies can offer significant advantages.
As we argued in a recent article, credit quality has become a more meaningful distinction than sector as emerging-market (EM) securities have started to behave more like their developed-market peers. In that discussion we argued that, for some investors, it made sense to have an investment-grade-only strategy. Now we'll look at what pure EM high yield (BATS:EMHY) has to offer.
Not so long ago, EMHY strategies were hampered by the geographic and industry concentrations that resulted from combining EM sovereign and corporate high-yield issuers. But, as shown in the chart below, today it's possible to assemble a reasonably diversified EMHY portfolio. The investable universe consists of roughly 56% sovereign debt, 7% quasi-sovereigns, and the rest corporates. Roughly equal proportions of issuers reside in Asia, Europe and Latin America, with Africa and the Middle East rounding out the rest. No single industry comprises more than 7.5% of the universe. One less favorable aspect is that estimated market capitalization is still only about $200 billion, much smaller than the U.S. high-yield market (around $1.1 trillion).
Why consider an EMHY strategy? In a world of very low global interest rates, yield is a strong motivation. By late February, EMHY was yielding about 5.9% -- roughly on par with the U.S. high-yield market. But note that the credit quality of the EMHY market is higher. For example, an estimated 49% of EMHY is rated BB, compared with 37% in the U.S. high-yield market. This obviously increases the relative attractiveness of EMHY.
For some investors, an even bigger potential attraction is EMHY's insensitivity to changes in U.S.-dollar interest rates. Rising interest rates are usually bad for bonds, so given unusually low rates in the leading developed economies, investors might be nervous about pursuing "yieldy" fixed-income strategies if rates are ultimately going to start rising. But, as the chart below shows, EMHY's total returns have historically been very weakly correlated with those of U.S. Treasuries -- certainly by comparison with EM investment grade.
This makes sense, because the "risk-free" U.S. interest-rate component is just a small part of the overall yield of an EM high-yield security. The credit spread accounts for most of the yield. So movements in U.S. rates need not be reflected in the overall yield, because the credit spread can provide a cushion. For example, as U.S. interest rates rise, a high-yielding security can absorb that rate rise with a reduction in its credit spread without changing the overall yield (and therefore the price) of that security. An investment-grade security has significantly less credit spread cushion and is therefore much more sensitive to movements in risk-free rates.
Consequently, for aggressive investors who are seeking yield in a low interest rate world but are concerned about the outlook for U.S. interest rates, EMHY might well be an attractive option.
Marco Santamaria is a portfolio manager, Emerging Market Debt at AllianceBernstein.
Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio managers.