Managing money in the current financial market is beginning to resemble the game of musical chairs I played years ago in grade school. Last year, at virtually the same moment in the year, the market "forces" decided that the music would stop and the debt market, primarily the longer duration bond market as well as high dividend paying stocks such as utilities (NYSEARCA:VPU), telecom (NYSE:VZ) (NYSE:T) and REITs (NYSEARCA:VNQ), would not have a seat at the table. Municipal bonds (NYSEARCA:MUB) last summer were also ostracized from the game, with the fears of bankruptcies in Detroit and Puerto Rico looming large and investors warned to stay away as the market was far too risky for entry.
The T-Bond (NYSEARCA:TLT) (NYSEARCA:TLH) (NYSEARCA:IEF) route moved the 10 year from around 2% in early 2013 to a high touching 3% precisely at year end. The longer duration securities such as the 30 year also traded down in value, up in yield in 2013, about 90 basis points to end the year at almost 4%. All the related interest-sensitive markets were beaten into submission going into yearend. Opportunities for savvy income investors were plentiful - for a brief moment.
Market Dancing to a Different Tune in 2014
Since the beginning of 2014, however, the music has been noticeably different. The 10 year has retraced 30-40 basis points of its 100 basis point decline in 2013. The longer duration market has fared even better with the 30 year retracing almost half of its 90 basis point decline. One aspect of the interest rate market that is decidedly different is that the yield curve is flatter, as the short end of the curve is beginning to show signs of moving higher as the inevitable Fed taper begins to gather momentum. In addition, longer duration treasury, municipal and corporate bonds (LAG) are currently very tight, with supply of high quality investment grade bonds limited. At the end of March the Moody's BAA1 seasoned long bond index stood at 4.98% and the GO Municipal Bond Buyer 20 year index was at 4.43%.
Almost on cue in 2014, just as last year, the beginning of the second quarter witnessed the music stopping, and a particular asset class finding itself without a seat at the table. This year it is the tech heavy NASDAQ (NASDAQ:QQQ). The signs were evident in the first quarter from the start of trade after the New Year the DOW (NYSEARCA:DIA) and S&P500 (NYSEARCA:SPY) both struggled and declined after their runs to end 2013 at all-time highs. During the 1st quarter the S&P managed to eke out a capital gain of 1.3%, while the DOW posted a quarterly loss of (.7%). The DOW did manage to run up an eclipse its previous all-time high during the 1st week of April. However, the time above the peak was brief, as the rout in the NASDAQ began to weigh on equities across the board.
The underlying dynamics in the current market game do not bode well for equities in the coming months, and possibly for a longer period of time. No doubt there will be repeated runs to try to drive the market higher, but there is a fundamental impediment that will be very difficult to overcome - the withdrawal of $85B a month in marginal demand for securities in the market by the Federal Reserve forecasted to end by the 4th quarter of 2014 that was in full effect during 2013. In addition, investors can assume that central banks in Japan and Europe will also back off their extraordinary programs. It does not take a genius to realize that this level of market participation at the levels being orchestrated by the Central Banks have had a significant impact on the margin for the price that can be obtained for risk assets as the bond buying efforts squeezed the market supply available for investable options. However, as the elephants vacate the market you can presume that in their wake the additional supply of Treasury bonds available is going to be a major stock market headwind. Since no investor (nor Fed Chair) has experienced a quantitative easing at the magnitude that has been undertaken, the consequences of the withdrawal are really likely to be a day-to-day reality show great for the ratings of CNBC and Bloomberg Television.
If You Sell, What Do You Do Next?
As I survey the market currently, the frustrating aspect is that very few places appear to have the combination of return, investment grade risk and market liquidity that do not seem to be bid up artificially by the Fed's "margin" account. Paying 3.5% for a 30 year T-bond when historical data show that 5% is the breakeven needed to truly hedge inflation risk is a tough trade for anyone but governmental entities. I guess that is why almost 50% of the U.S. Treasuries are held by foreign governments. Add to this total the 15% held by the U.S. Fed, and you are left with little support for the financing of the U.S. government directly from U.S. citizens other than entities mandated to buy the securities such as insurance companies. This fun fact is one reason I have always felt the true underlying rationale for Obamacare was to force a pool of domestic funds into the insurance industry that would find its way into the Treasury market. Nix that thought as the insurance program is more likely to be a net spending program demanding an ever higher level of funds through time unless there is a change down the road.
So what do investors looking to take equity risk off the table do at this juncture? One strategy which seems sound to me includes parking funds in cash or near cash (NYSEARCA:SHY) and gold (NYSEARCA:GLD) at this time and assessing momentum trades through time. (Read article: 'Scared' Dennis Gartman: Get out of stocks) Undoubtedly there will be market rebounds and mispriced securities in the NASDAQ market carnage.
Emerging Market Debt Rotation Opportunity
Not being a momentum trader, but a relative value portfolio investor with an income investing bias, my approach to the problem is slightly different. As many investors, through the last several years I have been repeatedly bumped out of good investments by the Fed program as borrowers have been able to refinance at lower rates. So my push into riskier assets has been selective into large cap dividend stocks and high yield plays. However, the risk reward in these sectors is not very attractive in my opinion at the present time as the rebounding market since the first of the year has driven price levels to high relative to the risk going forward.
There is one income-investing market sector, however, that on a relative basis, appears attractive currently - emerging market debt. To explain my rational for this opinion, the remainder of this article will focus on the historical performance of two emerging market income closed-end funds:
- Templeton Emerging Market Income Fund (NYSE:TEI)
- Western Asset Emerging Market Income Fund (NYSE:EMD)
I choose these funds for the long-term experience the fund managers have had in navigating these money markets (both were launched in 1993), and the high quality of performance in the funds with respect to preserving asset value while delivering a high, low to no leverage, ongoing return which rivals the return of major U.S. equity markets like the DOW or S&P 500.
As a start for analyzing the emerging market debt opportunity, I took a look at the last two years of asset value pricing for the emerging market funds relative the stock market using the S&P500 as a benchmark. Recognize that these assets have fundamental differences - the debt funds pay out a 7% - 8% return currently, and owners of the assets look to make sure they get there loaned funds repaid on an ongoing basis; the equity market pays a 1.5%-2% dividend historically and asset prices appreciate through time at some sustainable rate. So as an investor I expect to see a divergence over time between equity markets and debt markets from an underlying asset value perspective. However, markets do not seem to price on a relative basis in a perfect manner, particularly when central banks are driving the flow of funds as opposed to bank lending driving economic growth on a more gradual basis.
A large divergence in the emerging market debt market and the U.S. equity market can be seen beginning in the 2nd quarter of 2013 as shown in the graph below.
The sell-off in emerging market debt was severe, with a drop in debt values of 30% commonplace, and the TEI and EMD funds both exhibited large declines in both NAVs and traded market price levels. Meanwhile, the S&P500 over the same time period plowed 30% higher. This severe divergence over such a short period of time is not often recorded in the market. The decline followed 4 years of market trading in which the emerging markets were highly correlated to the price action of the S&P 500 coming off the market lows of the 2009 stock market bottom, as shown in the graph below.
The extreme emerging market price adjustment while equity markets go the opposite direction illustrated in the above graph is a market anomaly that is rare, but does have historical precedent that seasoned investors may have had experience with, most recently in the late 1990s. The similarity in market conditions are notable, although I will point out from the outset that the current Fed program is far more extensive in many ways, and there is also evidence that the NASDAQ valuations in the late 1990s were on a metric basis more stretched. However, the combination of government programs and human activity seem to have provided ingredients which are producing market pricing action that is highly similar in relative terms.
Take the graph below as a case study of how similar market dynamics in the late 1990s in the U.S. market were accompanied by a pricing breakdown in emerging market debt valuations. For readers who may not have the Fed policy and U.S. government fiscal spending data at their fingertips, there are several important aspects to Fed and fiscal policy that combine to put severe pressure on emerging markets. One was the decline in the available supply of Treasury securities for investment as new supply lessened while the U.S. headed to fiscal balance in 2000; and the second was that Greenspan liquefied the financial markets as there were fears of financial system turmoil that might be caused with the new millennium. In retrospect year 2000 worries were a huge non-event, but I remember the work I was involved in which began in 1996 preparing for telephone network equipment upgrades which needed to be put into place because of the original programming used only 2 digit fields for years. Go figure how that matches up with the high frequency trading algorithms driving prices in the market today.
In the above graph, note how an overly liquid Fed, a low growth rate in Treasury supply and a frenzied run-up in the NASDAQ all corresponded to a breakdown in the emerging debt markets of almost 40% on a principal value basis which lasted from the summer of 1998 (when Russia went bankrupt) until late in the year 2000. It was during the year 2000 that Greenspan had to do what would be termed today a historical tapering of easing measures as records show that during the year 2000 the Fed did very little bond buying while government spending began to pick up in pace.
Through time, the Fed lack of monetary support and other economic factors combined to produce a gradual, but prolonged decline in the stock market which had seen a large run-up beginning in 1995. On the other hand, emerging market debt, which experienced a dramatic spike down in price early in the musical chairs game in 1998 and 1999, maintained a relatively stable price level throughout the stock market decline period, while paying relatively high distribution rates.
Is the same future in store for these two markets over the next several years? I cannot be certain. But I will say that the information is compelling enough for me to recently up my allocation in the emerging market debt funds.
Closer Look at Specific Fund Option - TEI
As a reference, below I supply information about the two funds utilized in the emerging market financial analysis contained in this article. The facts about both funds can be obtained from the fund sponsor websites (Franklin Templeton Investments) (Legg Mason), on CEF Connect, or in the SEC filings for the specific fund (EMD filings) (TEI filings). As always, I recommend investors do their own homework.
In the case of the Templeton fund, I point out the lower duration of the fund driven by the 6.38 year average maturity as attractive. In the event that rates rise globally as central banks withdraw liquidity, the fund portfolio should adjust more quickly than longer duration plays. The fund has a positive UNII, and the distribution history as shown in the graph below has been stable. The positive UNII is a good sign that the fund is not likely to lower its distribution in the near future. The fund has a long history, and I am particularly impressed by the ability of the fund to maintain its NAV over time. So often closed end debt-oriented funds erode capital levels over time as they experience loan losses. The fund is one of the larger emerging market debt funds traded at $680.3M in size and is not leveraged, an aspect I prefer in a projected rising short-term rate environment.
The TEI fund is well diversified globally in emerging markets. If there is a risk that may cause nervousness among many investors at this time is the exposure to both the Ukraine and Russia, which combined is almost 10% of NAV. These are issues which any investor must understand their own risk tolerance level. One aspect of both of these funds, however, is that from a ratings standpoint, 80% or greater of their investments are in investment grade triple B of A rated securities. Obtaining a 7%-8% to return on a low duration investment grade security presently in the U.S. domestic market is rare if not totally obtainable.
Fund Option 2 Reviewed - EMD
The EMD fund has many of the same characteristics as the TEI fund. The primary differences are that the EMD fund provides a managed payout ratio, meaning that it tries to set the distribution to reflect income and realized capital gains (if any) through time, whereas TEI is an income distribution only fund which periodically distributes capital gains separately as it did in 2013.
EMD has a high positive level of UNII (undistributed net investment income) and a high current pay-out rate of 8.31%. It is also trading at a sizeable discount to NAV at -11.09%. Compared to TEI, the average maturity of its investments is longer at 10.5 years. This means that the fund's NAV is likely to go down a greater amount if rates rise in the future.
As shown in the graph below, the fund has about 80% of its assets invested in BBB, AA or A grade investments, with the majority of the remainder in high non-investment grade credits.
Just as with the TEI fund, EMD has a high (8.37%) level of debt investments in the recently volatile area of Russia. The fund also reports a high level of assets as US based, which refers to the debt held from multinational companies do business internationally.
Bottom Line on the Funds
Overall I do not rate either security as relatively better than the other; however, I typically would not enter a closed end fund above net asset value. TEI has aggressively traded up in recent weeks most likely reflecting its combination of lower duration, solid distribution rate and portfolio management expertise. The NAV has also risen over the time period. EMD appears at the moment to have a bit more near-term upside potential for the market to bid up relative to NAV.
Daniel Moore is the author of the book Theory of Financial Relativity: Investment Portfolio Guidance in a Federal Reserve Driven Bubble Prone Deflationary Era. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I am long TEI, EMD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.