“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” - William Arthur Ward
For the past few quarters City National Rochdale expected choppy seas in all markets as asset classes experienced heightened price volatility.
To the surprise of many investors, the Fed chose not to raise rates in September. However, the prospect of higher rates is not actually new to market participants. Over the past several years, yields on the two-year Treasury have risen from 0.24% (at year-end 2011) to 0.81%, (by mid-September 2015) while yields on the five-year Treasury moved from 0.83% to 1.61%. Both domestic and emerging market (EM) investors have had to adapt to an already rising rate environment. Historically, there have been periods of high correlations between U.S. Treasuries and EM bonds. However, this dynamic has changed since the taper tantrum of 2013, as investors have become more focused on country and issuer idiosyncratic risks.
According to the International Monetary Fund, EM corporate debt market grew from $4 trillion in 2004 to $18 trillion in 2014, with Chinese local currency debt accounting for a large percentage of the total outstanding. This growth in the EM corporate market is largely associated with favorable global conditions. For several years, most advanced economies have maintained stimulative monetary policies that spilled over into EM economies through capital flows and currency adjustments supporting respective country exports.
Since 2010, EM corporate leverage has steadily increased while profitability, interest coverage ratios, and liquidity metrics have all deteriorated, although from very robust levels. More recently, EM corporate fundamentals have come under more pressure due to weaker growth, lower commodity prices, and depreciating currencies. This downturn in fundamentals has resulted in a modest default rate of 2.5% year-to-date for emerging market high yield (EM HY) debt, according to J.P. Morgan, with the full 2015 EM HY forecasted default rate at 4.3% (heavily skewed to the metals/mining and energy sectors). Along with a general deterioration in EM corporate fundamentals, this forecast is also driven by the ongoing conflict in the Ukraine and fluid political dynamics of Brazil. Actively managed portfolios may be insulated from these countries.
With a base case outlook for subdued EM economic growth, (modestly) weakening EM corporate fundamentals, and an uptick in EM corporate defaults, why do we still find EM debt attractive? Despite the big picture trends, individual companies can still do quite well and represent attractive investment opportunities. A well-managed portfolio of EM HY assets that limits exposures to problematic countries, sectors, currencies, and maturities can provide additional diversification benefits and potential return enhancements to a stock and core bond port-folio. Moreover, EM HY provides meaningfully more yield per unit of risk (duration) than other credit risk-based asset classes. For example, at the end of the third quarter, the Barclays U.S. HY Index (U.S. HY bonds) had a yield of 8.04%, with an average duration of 4.39 years (183 basis points of spread/year), versus J.P. Morgan’s Corporate Emerging Markets Bond Index Broad Diversified High Yield (CEMBI BD HY), with a yield of 9.06%, and duration of 3.8 years (238 bps of spread/year).
Year-to-date performance (as of 9/30/15) illustrates the diversification benefit, as the CEMBI BD HY Index returned 0.24% (USD), while domestic U.S. HY bonds returned -2.45%, and the S&P 500 had a total return of -5.29%.
City National Rochdale, LLC is a Registered Investment Advisor and wholly owned subsidiary of City National Bank.
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Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.
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There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible. Investments in below-investment-grade debt securities and unrated securities of similar credit quality, commonly known as “junk bonds” or “high-yield securities,” may be subject to increased interest, credit, and liquidity risks.
Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging markets bonds can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.
Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy and market risk. Investors of MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated Schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Tax Income).
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Returns include the reinvestment of interest and dividends.
Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.
Past performance is no guarantee of future performance.
The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Industrial Average Index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.
The MSCI EAFE Index is an equity index which captures large and mid-cap representation across developed markets countries around the world, excluding the U.S. and Canada. Developed markets countries in the MSCI EAFE Index include: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The Barclays Aggregate Bond Index is comprised of U.S. government, mortgage-backed, asset-backed, and corporate fixed income securities with maturities of one year or more.
Producer Price Index measures the average changes in prices received by domestic producers for their output.
Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.
J.P. Morgan’s Corporate Emerging Markets Bond Index Broad Diversified High Yield (CEMBI BD HY) is a market capitalization weighted index consisting of US-dollar-denominated emerging market non-investment grade rated corporate bonds. According to J.P. Morgan, this index limits the weights of those index countries with larger corporate debt stocks by only including a specified portion of these countries’ eligible current face amounts of debt outstanding.
Alerian MLP Index is the leading gauge of large- and mid-cap energy Master Limited Partnerships (MLPs).
Barclays U.S. Corporate BBB OAS Index is the Baa component of the U.S. Corporate Investment Grade index. The U.S. Corporate Investment Grade Index is publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.
Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.