That this has happened should be of zero surprise given the rise in the 10-year Treasury yield from 1.70% to 2.40%, and the cyclical nature of investor attitudes.
Markit takes note of the wave of short-selling in fixed-income ETFs on both sides of the Atlantic, with total demand to borrow ETFs jumping by one third. Shorts are most active in high yield, emerging market, and other long-dated ETFs.
The most shorted ETFs are the two big junk bond funds (HYG, JNK), and shorts actually slipped a little in November for HYG, but rose 14% for JNK (hedgers likely make up a sizable number of shorts, one would think). Shorts in the investment-grade LQD fell 56%.
Shorts in the iShares JPMorgan USD Emerging Market Bond Fund (NYSEARCA:EMB) soared 111%.
Amid the panicky action in stocks to end last week, investors rushed to the exits on the previously red-hot iShares JPMorgan USD Emerging Markets Bond Fund (NYSEARCA:EMB), which suffered its largest-ever one-day withdrawal of funds.
Some estimates put the amount of global bonds trading with negative yields as high as $10T, so who could fault an investor for turning to emerging market paper as a way to eke out some income, says Brown Brothers Harriman.
The team notes portfolio investment flows into EM have been positive in four of the last five months, with the early signs pointing to a continuation of the trend in August.
While Brown Brothers sees more gains for EM credit, it waves the yellow flag: "A purely liquidity driven model of investing will work ... until it doesn't. We caution investors against getting too optimistic about EM, as fundamentals are lagging the price action."
The iShares JPMorgan USD Emerging Market Bond Fund (NYSEARCA:EEM) is higher by 10.7% YTD, while yielding north of 4%.
Holders of long-dated U.S. paper could see losses of more than 1% annually for the next five years, says the asset manager's Global CIO Richard Turnill.
What's a fixed-income investor to do? Higher returns are to be found in the debt of hard-currency emerging markets and high yield. For Turnill and team, EM debt is particularly attractive when compared to Treasurys over the next half-decade.
AUM at the iShares JPMorgan U.S. Dollar Emerging Market Bond Fund (NYSEARCA:EMB) surged to $6.5B last month, pushing it past the largest mutual fund in that category.
While the appeal of low-cost, passive funds is obvious in developed economies, their rise in emerging markets can be labeled at least somewhat surprising, thanks to the idea sharp managers should be able to more easily find and exploit profitable opportunities.
The reality though, is that active managers struggle to outperform, no matter the market.
"We’ve been outright reducing risk in some of the higher-risk, or more volatile, segments of the market,” says Pimco CIO Dan Ivascyn. “The emerging-market region has significant near-term challenges. From a shorter-term perspective, we’re much more cautious."
Emerging market bonds in April fell to 9.4% of assets at Pimco's Total Return Fund (MUTF:PTTRX)/ That's down from 28.9% just last August, and the lowest proportion since August 2014. Like other risk assets, emerging market paper has put in a whale of a rally since mid-February.
The Bloomberg USD Emerging Market Sovereign Bond Index is up 7.2% this year.
U.S. government paper holdings make up about 36% of the fund.
Emerging markets: iShares Core MSCI Emerging Markets (NYSEARCA:IEMG), SPDR MSCI Emerging Markets Quality Mix (NYSEARCA:QEMM), iShares MSCI Brazil Capped (NYSEARCA:EWZ), EGShares India Infrastructure (NYSEARCA:INXX) "We like India in general as a long-term option," iShares Latin America 40 (NYSEARCA:ILF) "We're starting to see governance improvements in Latin America broadly," iShares J.P. Morgan USD Emerging Markets Bond (NYSEARCA:EMB).
Emerging-market proxies: iShares MSCI Canada (NYSEARCA:EWC) and iShares MSCI Australia (NYSEARCA:EWA).
iShares Core High Dividend ETF (NYSEARCA:HDV). iShares MSCI USA Minimum Volatility (NYSEARCA:USMV) "Now there's more uncertainty, and that's when these low-vol strategies do best."
iShares North American Tech (NYSEARCA:IGM) and iShares U.S. Consumer Services (NYSEARCA:IYC), "We still like consumer services and technology."
PowerShares QQQ (NASDAQ:QQQ), Vanguard Small Cap Value (NYSEARCA:VBR), "Blending the two doesn't tilt the portfolio too much in one direction or the other, because the combination blends small and large, growth and value."
SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK), PowerShares Fundamental High Yield Corporate Bond Portfolio (NYSEARCA:PHB).
VanEck Vectors Fallen Angel High Yield Bond (NYSEARCA:ANGL), "These are viable companies, and although they've moved from investment- grade to high-yield, they're likely survivors."
"We like preferreds, via the iShares U.S. Preferred Stock (NYSEARCA:PFF)." Also: iShares International High Yield Bond ETF (BATS:HYXU).
"Hazard ahead: The emerging market credit cycle has turned down," is the title of a recent JPMorgan report, arguing credit markets will tighten as the Fed boosts rates.
A shoe not yet dropped, says the team, is that debt to GDP ratios are not decreasing.
"Remember that a lot of the credit growth in emerging markets is no more than the flip side of easy money in developed markets," and as the Fed normalizes, this can reverse, though Europe and Japan keeping their feet on the gas pedal should mitigate the turn.
The ratio of broad emerging market nonfinancial private credit to GDP hit 128% of GDP in Q1, up 51 percentage points from 2007. Exclude China, and the numbers are not nearly as gaudy, but still frothy, and the moves resemble those from that of developed markets in the years leading up to the global financial crisis.
Foreign inflows are set to halve to $548B this year and outflows are expected to come in at $540B. With local outflows accelerating, net flows will turn negative.
The flight from emerging markets "has been driven primarily by internal factors, basically reflecting a sustained slowdown in EM growth and amplified by rising uncertainty about China’s economy and policies," the IIF says.
EMs have also been hit by the commodities rout, to which many are exposed. Weak currencies and political turmoil in countries such as Brazil and Turkey are increasing the risks.
While those risks remain high, there is little incentive for investors to return to EMs.
Back in 1988, net capital market outflows were $9B, and they've been positive ever since. This year, according to the Institute of International Finance, net outflows are set to return to the tune of a whopping $540B.
Meanwhile Federated Investors portfolio manager Ruggero de'Rossi thinks now is the time to buy the dip in emerging market government bonds. The yield spread between sovereign EM debt and comparable U.S. Treasury paper has widened to 420 basis points from a recent low of 250 bps. He likes the risk/reward across a diverse array of EM countries. He's not so bullish on EM corporate debt, however, as many companies have not fully hedged exchange rate exposures.
Outflows from emerging market bond funds like EMB hit $4.2B in the week ending Aug. 26, the second-largest amount ever. Overall emerging market net outflows of $10.5B were the largest since early 2008.
Turning back to bond funds alone, outflows over the last three weeks of $7.5B represent 2.9% of AUM, says Morgan Stanley.
EMB is lower by more than 5% since a late-April high, and in stocks, EEM is off nearly 20% over the same time frame.
Facing decade-high inflation, a fiscal crisis and water rationing, more than a million Brazilians took to the streets last month to protest government corruption and mismanagement. In China, growth is slowing as property prices fall, propelling more than 1,000 iron ore mines toward financial collapse. In Russia, citizens are deserting their nation’s banks, switching savings into U.S. dollars. Such snapshots of growing distress in the world’s largest emerging markets are echoed among many of their smaller counterparts.
In aggregate, the 15 largest emerging economies experienced their biggest capital outflow since the crisis in the second half of last year.
These trends, analysts say, signal a “great unravelling” of an emerging markets debt binge that has swollen to unprecedented dimensions. The pain inflicted by this capital flight is being felt in the real-life economies of vulnerable countries and in a surging number of emerging market corporations that are forecast to default on their debts.
"Simple broad credit allocations are to be avoided," says Invesco Fixed Income Chief Strategist Rob Waldner. "With volatility comes opportunity, but it is more important than ever for investors to do detailed research to avoid credit accidents that are likely to come with increasing frequency in coming quarters.”
As for credit's troubles from the crash in oil , current market sentiment and pricing is pricing in a recovery in oil prices which isn't guaranteed to happen.
Waldner is particularly cautious on high-yield and emerging market debt - both sovereign and corporate.