Market volatility witnessed last Thursday and Friday caught many investors and market participants by surprise. Defenders of Emerging Markets (and other high risk asset classes) point out that not much has changed regarding the underlying fundamentals of most emerging market nations. There are indeed positives in emerging markets.
- Emerging Markets now account for about 50% of global consumption versus less than 40% 20 years ago.
- Emerging Market sovereign reserves are higher than they were during the so-called “Asian Contagion” which roiled emerging markets in 1997.
- Many emerging market economies are much more developed than they were two decades ago.
This does not mean that a downturn or even a full-blown correction in emerging markets is unwarranted. It is our view that (by and large) emerging market (and U.S. high yield debt) was overvalued versus fundamentals. This was due to a major technical factor; Fed policy.
Fed policy sent capital on a quest for yield. Capital found “opportunities” in areas of the market traditionally frequented only by speculative investors. Although some of the run-up in risk asset values (capital appreciation) was due to improving fundamentals, much of it was due to the quest for yield. As easy monetary conditions fade, institutional investors should shift their tactics from momentum strategies to fundamental strategies. Simply stated; when the Fed was extraordinarily accommodative there were no losers, only winners. However as monetary accommodation is wound down, the markets will look at fundamentals and pick winners and losers.
There could be however, a period of time in which even the winners are treated like losers. This is in line with our view that there could be Newtonian (equal and opposite) market reactions when the Fed removes accommodation versus when it was pouring the accommodation coal on the fire. We have seen this happen in the municipal debt market since last summer.
Everybody Get Together
Fears over Detroit, Puerto Rico and rising interest rates caused retail investors to exit the municipal bond market en masse. Many of these investors did not own actual bonds, but investment vehicles with exposure to municipal bonds. The result was that, when liquidation requests came in, portfolio managers were forced to sell healthy bonds as well as troubled securities to satisfy these requests. This presented opportunities for sophisticated investors who understood what was happening. A similar situation could be in the making in EM and U.S. junk debt.
Retail investors and advisors have been indoctrinated in investing in “macro” investments which have exposure the specific sectors of the capital markets. The upside of such broad exposure strategies is that investors can gain levels of diversification beyond what their investment capital could accomplish on its own. The downside of such strategies is that realized losses could occur if enough investors in a specific strategy (portfolio) decide to sell.
A portfolio manager often must sell what he or she can, rather than just what they should or would like to sell. In this scenario, diversification is not that effective as all asset prices within the portfolio are moving in the same direction due to momentum. This is the opposite and (possibly) equal scenario to the broad gains experienced during the past few years.
We believe the better way to speculate in an aggressive area of the fixed income markets is to build a portfolio of bonds in which risk analysis has been performed. By taking ownership of actual bonds, realized losses will not occur unless one actually sells one’s bonds. If one does not have the capital to construct a portfolio of bonds, it is our opinion that one should not participate in a high-risk fixed income sector.
There is one caveat to our view on high-risk fixed income investing. If one views EM or domestic junk bonds as total return investment vehicles, rather than as methods to enhance income, (and treat them similarly as equity investments) then one might wish to invest in sector-based fixed income investment strategies.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NYThomas ByrneDirector of Fixed IncomeWealth Strategies & Management LLC570-424-1555 Office570-234-6350 Cell
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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