Unique bond arbitrage opportunity bids well for investors

In the low interest rate environment prevailing since the 2008 financial crisis, many investors have turned towards more risky assets to secure enhanced returns. With the drop in government rates – the German ten year bund is currently trading at around 1.00%, compared to about 3.00% at the start of 2009 – spreads across traditional fixed income products compressed significantly, leaving investors in dire straits. Betting on the continuing recovery in developed countries, they primarily favored assets in those economies. This strategy has paid off.  It is, however, perhaps time for investors to revisit their allocation and consider the relative attractiveness of emerging market corporate bonds.

 

Over the last 18 months, three assets were in fashion with Euro-based investors: hybrid securities, peripheral bonds, and euro high yield markets. As European banks have been working on strengthening their balance sheets, investors became more and more prepared to buy deeply subordinate debt instruments that provide higher yields. So far this year, new issuance of hybrid securities has already reached USD 56.6 billion. On the same note, after the open support from the ECB in mid-2012, investors raised their holdings of peripheral sovereign bonds like Spain or Italy, and as a result, spreads have substantially shrank since then. The Spanish 10 year rate dropped from its all-time high, 7.62% in July 2012, to 2.40% mid-August 2014. Although not all investors can invest into high yield markets, money has been pouring into this asset class. The extended rally in the European high yield market combined with the re-pricing of emerging debt in 2013 has led to a situation where the yield curve of the European BB rated corporate bonds has been trading at levels which we feel remain unreasonably tight to emerging market BBB-rated corporate bonds (even considering the EUR – USD curve differential).  

 

This situation is due to several technical factors. In 2014, emerging corporate bonds went through a phase of spread adjustment following the announcement by the Fed Reserve of a tapering program at the time of lower economic growth in most of the emerging market countries. Concurrently, spread on high yield European names started to tighten significantly. As a result, one curve flattened while the other one steepened. Even adjusted for the fact that one curve is in Euro and the other one in US dollar, the yield curve of the European BB rated corporate bonds expressed in US dollar does not compensate enough investors for the risk that they are taking. The yield curve of the European BB rated corporate bonds expressed in USD is only marginally above the Emerging market BBB-rated corporate bonds (see corporate example below). And at a time when more and more market players are starting to talk about a potential market bubble in the European high yield market, European BB-rated corporate bonds appear at risk of a market correction. On the other hand, the economic situation is stabilizing in Emerging markets and inflows into the asset class are gaining momentum. Since the beginning of the year, USD 13.3 billion were invested in Emerging markets (hard currency debt).

 

If, however, investors would today switch from their BB-rated Euro High Yield bonds into the BBB-rated Emerging Markets bonds, they would not just reduce their credit risk but also optimize their risk budget. Emerging markets issuer ratings are just as stable as their peers in the US and Europe: the likelihood that an Emerging market BBB corporate issuer will be upgraded within a year is with 5.3 percent even higher than for their US or European counterpart (5.1 and 4.9 percent respectively). They are more likely to be more stable in their rating over their counterparts and less likely to be downgraded within a year. These figures, based on a one year average corporate transition rate by Standard & Poor´s over a time horizon of more than 30 years (1981 – 2013), provide a reassuring consistency for investors.

 

As a practical example to illustrate this arbitrage opportunity, we compare below two Telecom companies. Bharti Airtel is one of the leading Indian telecommunications companies and the world´s fourth largest mobile operator with business activities in 20 countries and almost 290 million customers. It is rated Baa3 by Moody’s and BBB- by S&P. Its dollar-denominated 10-year bond, due May 2024, is currently trading at a yield of 4.65%. Its European counterpart is Telecom Italia, the leading telecommunication company in Italy with 125 million customers in two countries. The company is rated Ba1/BB+. Its 10-year bond, due May 2024 and denominated in US Dollar, trades at a yield of 5.07%, which is only 42bp above Bharti Airtel 2024.

In the US dollar market, the spread differential between a BB+ and BBB- tends to vary in a range of 70 to 100bps. With only a 42-bp spread differential, the investment opportunity appears clearly to lie with the emerging market issuer.

 

In addition to the currently attractive market levels, we also see increasing support for emerging market debt from the recent ECB announcement that they were considering the possibility of implementing some quantitative easing. Indeed, additional liquidity would then likely flow to higher yielding asset classes and in the current context of depressed European economic growth and already tight Euro High Yield spreads, we think that EM markets are bound to benefit. In parallel, while US rates could grind higher, the risk of a sharp increase before year end is fading away in our view, which again should provide support to emerging bonds.

 

In summary, we believe that it is time for investors to review their bond portfolio allocation taking into consideration the current arbitrage opportunity offered by the attractiveness of emerging corporate bonds over their developed market peers.

 

About Denis Girault

Denis Girault joined UBP in 2007 from Barclays Capital, where he was a director in the debt origination group in Hong Kong. He also worked for Merrill Lynch in Hong Kong where he assumed several positions in both the risk management and debt origination groups. In New York and then Hong Kong, Denis was a research credit analyst on Asian debt issuers at BZW (now Barclays Capital). He started his career at Moody's Investors Service in New York where he managed various high yield portfolios. He also has participated to the development of the agency’s well known annual analysis of default and rating transition.

Denis holds a master in business administration from the University de Louvain, Belgium and an undergraduate degree in economics from the University de Strasbourg, France.

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