Wednesday, June 5th, 2013

Bonds Are Not Created Equal

Many US investors are brought up with the idea that US high yield bonds and emerging market sovereign bonds are similar asset classes. Both are priced off US treasuries; and both are subject to US law. Investors normally regard these assets as being closely correlated beneficiaries of the search for yield, which drives fixed-income investors out of Treasuries whenever risk-free rates are too low. It’s a sensible theory, and most of the time the gross returns are well-correlated. For the last two years the average reading is 60% (52 week co-incident).

However risk conditions have not always been well-correlated over the last 17 years. For the whole of the period, median volatility is broadly similar: 7.7% for emerging market bonds vs 6.3% for US high yield. But there is a huge variation in the gap between these two numbers over time. Emerging market volatility ranges from 600 bps above US high yield (2004 & 2005) to 600 bps below (2010) and there is normally an easily identifiable trend of rising or falling excess volatility. Right now the trend is rising. From a level of 400 bps below US high yield in March 2013, emerging market bond volatility is now 300 bps above high yield, and still rising.

There are many possible interpretations of this data. One would be that US high yield volatility is well below its long run average and that it will have to rise sharply as and when the Fed decides to taper its QE program. Another would be that emerging market volatility is poised to go higher as investors react to increasing evidence of a slowdown in China and the stresses imposed by a weaker yen.

What we can say for certain is that return per unit of risk has moved dramatically in favour of US high yield. We don’t need any economic forecasts to tell us this. If we pay close attention to market conditions and respond accordingly, we can make the adjustment to our portfolio long before the economists have worked out what they should be looking at. Emerging market bonds were our most preferred asset class from August to November 2012; since March 2013, they have been our least preferred, while the ranking of US high yield has been virtually the same for the whole of this time. Correlation of returns is only one part of the story.

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