After falling to extraordinarily low levels in the middle of 2014, volatility in many of the world’s bond and currency markets has leapt in the past two months. Developed market investment grade and high yield corporate bond spreads are widening again, after the recovery from the January highs. Emerging markets are on the slide again, with currencies particularly weak against the US Dollar in spite of the Dollar making little headway against the euro since October. With the sharp fall of c.30% in oil prices since the end of October, oil exporting country assets – whether equities, bonds or currencies – have suffered worst.
The result is that for the first time in a while, value is starting to reappear.
Almost a year ago, in January, such value appeared in Brazil – domestic bond yields soared to 13.5% p.a. and the
currency had weakened by around 20% over the prior year. The media headlines were awful; Brazil’s membership of the so-called ‘Fragile Five’ (those countries with large current account deficits) rendered it a basket case. There was talk of the country’s US Dollar bonds losing their investment grade status and being downgraded to junk.
But Brazil’s current account deficit as a percentage of GDP wasn’t, and isn’t, that alarming – for example, the UK’s deficit was, and is, much larger. Even the country’s government debt burden was a manageable 55% of GDP. Therefore, we were happy to retain, and even increase, our Brazilian exposure towards 20% of the Fund – represented by around 8% in US Dollar bonds and 12% in (more risky) local currency Brazilian real bonds. That strategy has been friendly to us this year, contributing around 2.5% to the Fund’s performance – in spite of the central bank continuing to raise rates and the currency being even weaker. It demonstrates the benefit of investing in risky markets during collapses or times of stress, when yields rise and currencies fall substantially.
Today, it is Russia that is making the headlines. Russian 5-year US Dollar bond yields have now reached nearly 7% p.a. or 550 bps above equivalent US Treasuries. Local currency bond yields have soared to nearly 13% p.a. and the currency has had what can only be described as a collapse. The Rouble has now depreciated by over 40% since the end of June. As with the case of Brazil a year ago, the headlines about Russia are nasty. There is talk of
a downgrade to junk status although the US Dollar bond yields discount much of that contingency. There is also talk of capital controls, although we believe embarrassment will feed Putin’s reluctance to pursue that outcome.
What makes Russia particularly interesting at these levels is that on pure fundamentals, it ranks strongly. The chart below (Fig 1) shows IMF 2015 forecasts for three key indicators for bond and currency investors: the current account, budget deficits and government debt, all as a percent of GDP. Russia ranks well relative to many developed countries, let alone other emerging markets.
Fig 1: Fundamental Indicators: budget balances, current account balances and government debt (% GDP). IMF 2015 forecasts.
Russia has a current account surplus and the IMF expects this surplus to be maintained (at 3% of GDP) as lower imports offset lower commodity export revenues. Its budget is almost in balance (-1% of GDP), and the IMF forecasts a similar outcome in 2015 as the weaker ruble and reduced government spending offset lower dollar oil revenues. Government debt is set to remain, at just over 16% of GDP, extremely low by international standards. Foreign reserves stand at more than USD400 billion, and the recent, highly orthodox decision to move to a free float of the ruble means that these reserves are available to give the authorities considerable flexibility to mitigate unexpected shocks.
Russia therefore finds itself in a very different place than it did in 1998, when incapacity to pay led to a default on both US Dollar and ruble debt. Russia maintains substantial capacity and, we believe, willingness to pay. As we did in the case of Brazil, we have therefore been building a position in Russian assets; not only in US Dollar bonds, but also in local currency bonds and currency. We started buying in September, after the currency had fallen 15%. By the end of October, the currency had fallen another 10% and we added to the position. Since then the currency has fallen a further 20% and we have again increased our exposure.
Fig 2: Around the World in One Bond Chart
Currently our exposure to Russia is a total of 14% of the Fund: 7% in US Dollar bonds (yielding nearly 7% p.a.), 3.5% in local currency bonds (yielding nearly 13% p.a.) and an additional 3.5% in currency forwards (effectively yielding around 15% p.a.). We intend to continue adding to these exposures with an intended maximum target of 20% of the Fund – consistent with our positioning in Brazil earlier in the year. A majority of the Fund’s current negative total return this year (around 4%, depending on share class) is explained by the positions we have initiated in Russia alone; but as we increase the exposure and Russia stabilises, we expect to recover that ground quickly.
The recent volatility will take more prisoners, not all of which will be opportunities yet. For example, we expect 2015 may deliver at least two sovereign defaults in Venezuela and Ukraine – bond prices in both are dropping sharply now. Defaults and/or debt restructurings may present us with opportunities to invest. Some African countries are also starting to feel the heat. also, some US Dollar bonds have fallen 15% in two months and, on the local currency side, Nigerian bonds and currency have been under huge pressure for months. There might be opportunities in due course.
Meanwhile, high yield corporate bonds are feeling the pressure again, especially following the sharp fall in oil prices. This is more relevant in the U.S., where a higher proportion (17%) of high yield indices is represented by oil or energy-related companies. Our short exposure to high yield corporate bonds is more biased in favour of the U.S., which has benefited the Fund recently. At some point there will be an opportunity to switch the short position to the (more expensive) European sector. For 2014 so far, the drag from our short position in corporate high yield bonds has been, approximately, a modest 1% i.e. substantially less than last year. This seems to be a reasonable price for insurance against substantial falls in corporate bond prices, should they occur.
Many of these themes are summarised in the chart (Fig 2). On the local currency side, Brazil and Russia seem to be (“cheap”) outliers, while on the US Dollar side, Russia stands out. These represent opportunities because we are comfortable with the fundamentals of both countries. Corporate bond valuations, by contrast, continue to look rich.
