Like many other fixed-income assets, emerging markets external (sovereign) debt has rallied sharply in recent weeks. While EMD has not moved as dramatically as high yield in the wake of the Federal Reserve’s QE3 announcement, its spread has continued a narrowing trend that began in early June. Since the end of May, the EMBI Global Diversified spread has fallen 135bp. With U.S. Treasuries not moving much, the all-in yield in the EMBIG-Div, which dropped below 5 percent in mid-July, now stands just above 4.5 percent. At first glance, this yield, meager by long-run EMD standards, may not seem very appealing.
Two factors, though, make EMD still worth considering. First, while slight compared with their long-run average, spreads remain reasonable next to their more recent history, in this case the more relevant benchmark. Second, while yields have shrunk across the fixed-income universe, implied volatility in the U.S. Treasury market has also faded. To the extent that this low-volatility environment persists, Sharpe ratios in various credit markets may remain interesting even with prosaic headline yields.
Since the start of 1994, the EMBIG spread has averaged about 570bp over Treasuries. EM creditworthiness has improved significantly over the long run. The average credit rating of the EMBIG has risen almost continuously since the early 2000s, and much of the index now stands in investment-grade territory. The warranted credit spread, then, has likely narrowed over time, rendering long-run spread comparisons misleading. In this respect, EMD differs from, say, high yield, where credit quality is by definition constrained, and where spread levels can safely be checked against the entire history of the market. EMD spreads during 2005-07 and 2010-present (taking out the crisis period, when spreads blew out) have averaged 280bp. In that sense, today’s spread level seems broadly fair, even assuming no further improvement in creditworthiness. EM credit ratings, though, likely will continue to improve, given the faster trend pace of growth in EM economies than in the developed world and taking into account the positive correlation between per-capita GDP and perceived creditworthiness.
EMBIG Diversified yield to maturity and spread over U.S. Treasuries (%)
| Source: JPMSI; data through September 20, 2012 |
EMBIG average credit rating
| Source: JPMSI, JPMAM; data as of July 2012; ratings expressed on arithmetic scale with lower numbers implying higher ratings |
Even if spreads are not expensive, though, the extraordinary atmosphere in the U.S. Treasury market is leaving the all-in EMD yield at strikingly low levels even by recent standards. The EMBIG-Div yields just 4.6 percent at the moment, a figure historically more associated with investment-grade U.S. corporates or even Treasuries themselves. The low level of yields can create a sense of sticker shock, not just in EMD but throughout the fixed-income universe (something similar has happened in high yield, for example, which stands barely above 6 percent in yield-to-worst terms). In this context, though, another current feature of fixed-income markets bears attention: the low level of volatility. Implied volatility across the U.S. Treasury yield curve has faded throughout 2012 and is now running at less than 60 percent of its long-run average – a level comparable to the one prevailing in the mid-2000s, during the so-called “Great Moderation.”
MOVE (U.S. Treasury implied volatility)
| Source: Bloomberg; data through September 20, 2012 |
What accounts for such low market volatility in a global atmosphere that feels turbulent? It appears that strong but opposing forces present in the Treasury market are constraining outcomes on either side, thus dampening volatility, a situation that may persist for some time. On the one hand, Treasuries are experiencing severe downward pressure on yields, both cyclical and structural. The macroeconomic environment favors low yields, with growth sluggish, central banks turning ever more stimulative, and genuine inflation fears remote. Meanwhile, a safe-asset shortage appears to have developed in recent years with demand for risk-free securities elevated and the supply of such assets having shrunk. The Fed’s recent action reinforced these points. Not only did the FOMC anchor short-term rates near zero for an even longer period than before, it made this pledge somewhat less sensitive to the near-term growth outlook. Meanwhile, the resumption of asset purchases suggests that the Fed will be taking duration out of the market for an extended period. At the same time, Treasury yields likely face a practical floor, and one that lies not far below the levels reached this year. U.S.-based investors, who face a 2% inflation environment, may not accept yields significantly below 1.50% for 10-year maturities. And 2-year yields at 0.25% do not have much farther to fall. Treasury yields thus appear caught in a sandwich, with strong downward influences but little room to decline. In this atmosphere of constrained market outcomes, a fall in implied volatility makes sense.
If this low-volatility environment continues, EMD yields that appear modest by medium-term standards become more interesting. In a low-vol world, a 4.5% yield with minimal defaults and improving credit trends may produce an attractive Sharpe ratio. Investors who accept the premise that low-vol may be here to stay, at least for a while, may need to consider modifying their thinking about yield levels in that looks increasingly like a coupon-clipping world.
