iShares’ Koesterich explores US investment grade and emerging market debt
Russ Koesterich, iShares global chief investment strategist at BlackRock, explores has been looking at the opportunities in US and emerging market debt.
Over the past year, the slow evaporation of fixed income yield has turned into a vanishing act. The yield picture looks even starker when taking into account inflation or inflation expectations.
We believe it is a mistake to seek incremental yield in the form of longer duration. While yields could certainly go lower in the event of another crisis or a sustained bout of deflation, long term there is a greater risk of inflation than deflation.
US Treasuries: investors settling for lower returns and taking more risk
• Today’s investor in a long-dated US Treasury is not merely settling for lower returns but also taking on considerably more risk. Even a modest rise in rates will result in greater losses for holders of long-dared Treasuries.
Should emerging market debt command a higher allocation?
• To the extent that emerging market relative volatility is falling, this asset class should command a higher allocation in a portfolio.
• Although emerging market bonds are still more volatile than domestic, they add diversification and – for those willing to accept volatility from currency exposure – a hedge on an erosion in the dollar.
• While investors in emerging markets were reasonably concerned about inflation in 2011, this appears to be a fading risk. With the exception of India, a deceleration in inflation is already evident in most of the large emerging market countries.
• Despite the improvement in fundamentals, emerging market bonds are offering significant and historically high premium over most developed market debt. Currently, emerging market bonds are yielding roughly 350bps over the 10-year Treasury, close to a record high.
Where can high yield go from here?
• High yield spreads have already compressed, falling from 750 bps over 10-year Treasuries in September to 500 bps by the end of February. As a result, we see a place for high yield but would not be aggressive in overweighting it.
• High yield spreads tend to be very sensitive to economic expectations. Should the economy accelerate further, then we would expect further tightening. However, should growth remain at or around the 2% level, then we would expect that most of the easy gains in high yield have already occurred.
• While stocks and high yield bonds have been the main beneficiaries of risk on trade, we see particularly good relative value in part of the investment grade spectrum, particularly the lower strata.
Top picks: For those willing to accept higher risk, US investment grade and emerging market debt
• Whether by design or as an acceptable casualty in their attempt to cushion the aftermath of the financial crisis, developed market central banks have left fixed income investors with a difficult choice: move further out on the risk curve or accept lower yields. And for those willing to take on marginal risk, there is still the decision of which risks to take.
• US investment grade and emerging markets appear reasonably priced, and evidence solid fundamentals. The risk is that both are, to varying degrees, vulnerable to another bout of risk aversion. But under that scenario, as last summer demonstrated, there is little to do other than follow the Fed and load up on Treasuries, at any price.