The bond rout of the last few months has made the global investment community increasingly polarized in regards to the fate of emerging market (NYSE:EM) corporate bonds, the market's highest yielding segment. Will EM corporate credit (NASDAQ:EMCB) sustain its tight spreads over their sovereign counterparts or will they collapse when the great global margin call knocks investors' door? Despite the fact that the outperformance of corporate bonds after the great bond debacle of 1994 looks similar to the current setup, a particular difference points to a riskier environment today. The nature of carry trades today is based on taking advantage of different rates between currencies and regions, while in 1994 investors had been chasing the steep yield curve opportunities within the same currency and market. Today, speculators borrow in low yielding currencies, with the US dollar as the predominant funding currency, and invest the proceeds in higher yielding EM bonds. This creates a leveraged exposure to EM debt, either US-dollar (NYSEARCA:EMB) or local currency (NYSEARCA:EMLC) denominated, in a different macro backdrop than in 1994. Under this light, the direct comparison of today's EM corporate bond dynamics with that of 1994 can catch investors completely off-guard, exposing them in excessive speculation and a subsequent capital flight out of EM economies, if the avalanche of margin calls begins. This chain reaction can potentially be initiated if either sovereign bond yields climb substantially higher or the greenback gets significantly stronger.
Why today Is Not 1994
Analysts base their optimism about the on-going outperformance of EM corporate bonds on their 1994 experience. However current bond setup is completely different than in the 1994 case and comparative analysis between these two periods should be taken with a grain of salt.
At the time, the massive US Treasuries and global sovereign bonds' sell-off in the wake of the expansionary economic policy of Bill Clinton, was followed by a solid equities and high-yield credit performance. The bond rout was confined in the sovereign bond market, since the steep yield curve has attracted excessive speculation in the form of carry trades. In particular, hedge funds and other speculators have been engaged in a highly risky tactic; they borrowed money by paying the low short-term US rates and invested the proceeds in long-term US Treasuries which were yielding much higher rates. The US yield curve was extremely steep at the time, allowing for this type of carry trades to be executed en masse.
In particular, the gap between the 3-month Treasury bill and the 10-Year Treasury Note yields has been skyrocketing from as low as 0% in the early 1990's to as high as 3.5% in early 1994. This steepening move allowed speculators to borrow in the low short-term interest rates and invest in the long-term yields, reaping the difference. The leveraged positions of this kind of carry trade, involved an initial deposit of a very small margin (of the order of 1% of the nominal value of the Treasury security) in order to invest in a position funded by the primary dealers in the US Treasuries market. As long as the 10-year yields were falling, the US Treasuries carry trade kept outperforming, as speculators enjoyed healthy capital gains on their leveraged positions. These gains were due to the appreciation of long-term bond's prices, as bond prices move in the opposite direction of yields.
However, things began to turn sour when the long-term yields of the US bonds turned to the upside. From 5.2% on late 2013 they spiked to 8% in late 2014, causing massive capital losses and multiple margin calls on speculators leveraged long positons on long-term US Treasuries. These margin calls prompted a lot of underfunded speculators to dump their Treasury holdings or default into their obligations towards the primary bond dealers. As a result, the sell-off in long-term US Treasuries, initially prompted by a new reflationary macro dynamic, intensified by the unwinding of these huge carry trades. The biggest bond rout in history unveiled.
Nevertheless, equities markets as well as corporate bonds didn't plummet as was expected. The corporate credit spreads kept tight in the following months and those investors who remained faithful on the corporate sector were more than compensated for their patience. This experience led some investment firms today to claim that the EM corporate bonds could remain similarly insulated from the global government bond rout. While this view seems to have a merit, the nature of the on-going global carry trade makes things trickier than they seem.
Given the extremely low yielding long-term sovereign bond yields and the flat yield curves in the advanced world, investors have hunted for yield in the EM corporate credit, with the high yield segment attracting the highest interest. This hunt for yield gave birth to a new global carry trade; borrowing in short-term US rates and investing in high-yielding EM corporate bonds of the full credit quality spectrum. This makes the current carry trade look completely different than that of 1994. Currently, the trade involves the flow of money from one geographic market and curencyto another, while in 1994 the trade involved leveraged investments in different maturities of the same currency and market.
Today, it's not the margin calls on long-term US Treasuries which drive the soaring long-term yields. The same cannot be said, though, about the risk of potential margin calls on EM corporate credit, especially that of the high-yield type. What could trigger such consecutive margin calls? Simply, the continuation of the global sovereign bond bear market.
The mechanism that might trigger an avalanche margin calls is as follows; as EM sovereign bond yields go up so do their corporate counterparts, assuming the corporate spreads remain more or less stable. This drags corporate bond prices down, triggering an eventual margin call on highly leveraged positions. The higher the sovereign yields go, the higher the probability that margin calls will be triggered, and the higher the chance that a forced liquidation of EM credit will ensue. This means that investors with margin calls would have to exchange more dollars into Asian EM currencies, for example, to fill the funding gap, or be forced to liquidate their positions, inflicting more pressure on corporate bond prices.
That being said, the current global setup in fixed income markets is completely different than that of 1994, with the evolving US Treasuries bond rout paving the ground for a possible EM corporate credit rout. If this chain reaction initiates, then some devastating side-effects could make things even worse. A potential EM corporate credit rout could add upward pressure to the US dollar, since fearful investors would rush to exchange their local currency holdings back to the US dollar. Under an EM bond panic investors would dump their EM corporate credit and exchange their local currency proceeds into US dollars, pushing the greenback's price up in a generalized way. In such a scenario, the USD funding shortage, already prevalent especially in EM Asia, would force global banks to cut their credit provision and ignite a vicious down spiral of EM fallout.
Macro Backdrop Different than 1994
Having said these, a natural question arises. Is the actual macro dynamics of EM economies the factor which poses the greatest risk for an EM corporate credit rout or simply investors' excessive speculation? The answer will become evident if we take a look at the current account dynamics (C/A) of EM economies. Take, as an example, the C/A balances, i.e. the difference between what the country earns from international trade of goods and services as well as the balance between incoming and outgoing remittances, of some of the biggest Asian exporters. China has built sizeable C/A surpluses in the last fifteen or so years, amassing the world's biggest foreign exchange reserves, in contrast with its closed-economy position in early 1990's. South Korea with a mostly negative C/A position back in 1994 has turned into a strong C/A surplus in the last few years, meaning that increasingly more money is credited in the country than is debited. Singapore and Taiwan exhibit historically high C/A surpluses in contrast with the positive but minuscule surpluses they experienced back in early 1990's.Thailand recorded strong C/A surpluses in the last two years, while back in early-to-mid 1990's it suffered from persistent deficits. Also, EM economies are certainly in no overheating position currently, a dynamic which back in mid-1990's created the circumstances for the Asian financial crisis of 97-98.
All these considerations show that it is not the actual macro backdrop in emerging markets that poses the greatest risk, but the great migration of investors towards EM high yielding bonds. This crowded trade could be forced into a fierce unwind by the same market which put it in motion at the first place; government bonds, and their on-going bear market. It's not always fundamentals which dictate the fate of markets. Investors' excessive betting over specific outcomes might turn the world upside down, and EM high yielding bonds could potentially prove that painful reality.
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