Bonds have been a terrible investment YTD as their price had to adjust to one of the most aggressive monetary tightening cycles in recent history. Economists were particularly worried about emerging markets ("EM") since there is a clear historical correlation between financial crises in EM and the Fed's hawkish monetary policy. While inflation expectations have come down in recent weeks in the US, I personally believe an elevated level of inflation is here to stay for some time. Moreover, a slowdown in economic activity could add further downside risk over the next couple of months. In this context, EM high yield ("HY") bonds are risky to own for the moment, regardless of how high their yield is.
The VanEck Vectors Emerging Markets High Yield Bond ETF (NYSEARCA:HYEM) tracks the performance of the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index. The fund invests in USD-denominated emerging markets bonds that are rated below investment grade.
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Over 86% of funds are invested in emerging market corporate bonds, followed by government bonds which have an ~11% allocation. Corporate bonds are generally seen as riskier than government bonds since governments can always print more money in order to service their debt.
~55% of issuers are rated BB, which is a credit rating just below investment grade. This is a speculative rating, and it is generally assigned to companies facing financial uncertainties and/or who are vulnerable to adverse economic conditions. ~43% of assets are rated B and below. These securities carry high default risk. Finally, less than 3% is assigned to BBB-rated bonds, which is in line with the strategy's goal of investing primarily in corporate junk bonds.
According to Morningstar, the portfolio's average maturity is ~9 years. Over 45% of constituents have a maturity of more than 5 years, which doesn't surprise me since the portfolio is trying to maximize the yield.
The fund is currently invested in 748 different bonds. The top ten holdings account for ~7% of the portfolio, with no single issuer weighing more than 2%. All in all, HYEM is very well-diversified across issuers.
Based on data from Morningstar, the fund has an effective duration of ~3.8, meaning that for each 1% increase in interest rates, the portfolio's NAV is expected to decrease by 3.8%.
HYEM offers a 6% TTM dividend yield, which is one of the reasons why this fund is popular among income investors. This is much higher than what you could get on a standard emerging market ETF such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB).
Despite the relatively high dividend yield, investors should be aware of the risks of investing in HYEM in the current market environment. The probability of an EM debt crisis continues to be high. As rates throughout the world are rising, capital is flowing away from vulnerable countries into developed economies. The Fed plays a particularly powerful role on this topic, and investors have seen numerous times how rising US rates are destabilizing emerging market economies.
The Fed has recently embarked on one of the most aggressive monetary tightening cycles in recent history and this had a direct impact on Treasury yields. The 10-year US Treasury yield more than doubled YoY to reach ~3.1% in early May 2022, becoming more attractive for foreign investors in the process.
We are now below the 10y yield high as inflation expectations are coming down in the US. The market is betting that we have seen peak inflation in April 2022, as reflected by the 5y/5y breakeven rate and the U.S. 10y TIPS breakeven rate. While this should be interpreted as a bullish indicator for high-yield EM bonds, I personally believe inflation isn't something that goes away so easily and we have countless examples in the past showing that inflation is sticky once it becomes entrenched.
If we take the example of energy, we are now facing a real supply shock as inventories and spare production capacity are at historical lows, while demand continues to be strong going into the summer. Natural gas recently reached its 2008 high and crude oil fluctuates within a $105 to 110/bbl range for some time now. As long as demand is strong, energy will add further inflationary pressures.
Energy isn't the only sector where inflation hasn't peaked. Global food prices are on the rise since the COVID-19 lows in March 2020. The war in Ukraine only exacerbated this problem, but the trend already started well before that. As a result, I think inflation shouldn't be removed from the equation so fast unless demand quickly plummets. If inflation is persistent at this level, it could have an important impact on where the Fed sees its neutral rate and that could lead to further selling in the bond market.
Speaking of weakening demand, this scenario could very well materialize if we enter into a global recession. A global recession could have far-reaching consequences for EM given the fact that capital will move to safe-haven assets, leading to a dramatic sell-off in EM junk bonds. I believe this scenario is more plausible than a few months ago as illustrated by the recent increase in high yield EM option-adjusted spreads. However, we are still far from 2016 and 2020's highs, suggesting we haven't seen real stress yet, let alone a bottom.
I believe concerns surrounding a potential EM debt crisis are real and should be seriously considered by investors before purchasing HYEM. Despite the attractive yield, there are several risks such as unexpected higher inflation or a global recession that could impair the long-term performance of HY EM bonds. The option-adjusted spreads indicate the market is starting to price in some of the risks, but we are still far from the 2020 peak, suggesting a bottom in HY EM bonds prices might not be in yet.
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