As Treasury yields rise, don’t discount the returns in emerging markets – just yet
Nicholas Spiro says rising Treasury yields might be a call to shift investment away from high-yield bonds but, when adjusted for inflation, emerging markets still look attractive
This week, the 3-month Treasury yield was approaching the 2 per cent mark for the first time since the global financial crisis. In a sign of the extent to which the financial landscape has changed since the end of last year, risk-free cash-like instruments such as short-dated US government debt are starting to offer investors a decent return.
The 3-month Treasury yield – which currently stands at almost the same level at which its benchmark 10-year equivalent stood last September – now offers investors the same return as the dividend yield of the S&P 500 equity index.
Make no mistake, cash is no longer trash. This ought to give international investors pause for thought.
It has been the meagre post-crisis returns offered by cash and safer government bonds that have been underpinning demand for higher-yielding investments such as alternative assets, emerging markets and sub-investment grade, or “junk”, bonds. Over the past several years, large institutional investors, including pension funds and insurance firms, have been forced to venture into riskier parts of the financial markets which they would otherwise have never allocated money to.
Yet, as the International Monetary Fund rightly noted in its latest Global Financial Stability Report published last month, this “hunt for yield”, which was triggered by central banks’ ultra-loose monetary policies, has led to “speculative overreach in some risky assets” as the Fed raises interest rates and financial conditions begin to tighten.
On Tuesday, the benchmark 10-year Treasury yield shot up to its highest level since 2011 in response to signs of a stronger US economy, pushing up the dollar index (a gauge of the greenback’s performance against a basket of other currencies) to its highest level this year and fuelling speculation that the Fed will raise rates more aggressively.
The combination of more attractive returns on safer US government bonds, particularly at the front end of the yield curve, and a stronger dollar that raises the cost of servicing dollar-denominated debt is putting emerging markets under significant strain, turning one of the most popular hunting grounds for yield-hungry investors into a more dangerous place.
Buyers of Argentina’s 100-year dollar-denominated bond, which was sold with great fanfare last June, have been left nursing heavy losses as a full-blown currency crisis forces South America’s second-largest economy to once again turn to the IMF for a rescue package. Meanwhile, debt investors in Turkey, a more actively traded emerging market, have been hit hard as the country’s currency has lost a further 10 per cent against the dollar just in the last month.
Other emerging markets have also suffered. A JPMorgan index for emerging market government bonds in local currencies – which offer investors even higher yields than dollar-denominated debt – has lost 6.4 per cent in dollar terms over the past month after gaining nearly 13 per cent last year.
This begs the question: have yield-chasing strategies backfired and should investors be moving out of risky assets into safer investments?
While the rise in US bond yields and the dollar are certainly fuelling risk aversion, the fact remains that real yields, which account for inflation, stand at very low levels. The real 10-year Treasury yield is below 1 per cent and has yet to break out of its long-standing trading range. Nominal yields in Europe and Japan, moreover, are even lower, and remain in negative territory on shorter-dated and intermediate maturities.
Real bond yields in many emerging markets, on the other hand, are much higher due to relatively subdued inflation. Brazil’s real 10-year yield is above 7 per cent while those of South Africa and Indonesia stand at 4.5 per cent and 3.5 per cent respectively.
With monetary policy in Europe and Japan likely to remain ultra-accommodative for a considerable period, and with little sign of inflation in the US getting out of control, yields in developed markets are likely to remain at relatively low levels.
The fact is that yield-seeking investors cannot afford to get out of risky assets – at least not yet.
What is more, there is little indication that investors are giving up on emerging markets – quite the opposite. Shorting, or selling, the dollar still remains one of the most popular trades, according to the results of this month’s global fund manager survey published by Bank of America Merrill Lynch on Tuesday.
A lack of conviction in the dollar’s rally bodes well for the hunt for yield.
Nicholas Spiro is a partner at Lauressa Advisory