Phil Milburn (pictured), fixed income manager at Kames Capital, says in a note that the sovereign crisis could get worse before it gets better, but that with bad news priced into corporate bonds already the time to buy is approaching.
However, we cannot rule out a further overshoot as the high yield asset class is always vulnerable in a broad ‘risk-off’ environment. To protect against further asset class weakness we have identified and implemented a cheap hedge. We have purchased a 15% weighting in protection on the CDX EM index (series 15) which is a CDS index of hard currency sovereign emerging markets (EM) issuers. The spread differential between EM and high yield is at its all-time widest level. Whilst we believe EM economies can grow far faster than developed markets, the two sets of economies are intrinsically linked by trade and financial flows. A Western growth slowdown will undoubtedly impinge upon EM, and our analysis suggests that EM prices are being supported by the strong flows of cash that have been attracted into the asset class.
If risk perceptions change, these flows could rapidly reverse – perhaps the 50 basis points rate cut in Brazil is suggestive that there is cyclical risk within the structural EM story. We explicitly accept that this is not a perfect hedge, but the extreme valuation differential means we have to sacrifice very little yield on the Fund to meaningfully reduce risk.
US Non-Agency RMBS
Unsurprisingly, Non-Agency RMBS came under pressure as other risk markets sold off. Nonetheless, the bonds have performed better than risky high yield or subordinated financials. The deals we are invested in continue to amortise (pay down capital) at a good rate monthly and we believe there is great value in this often neglected part of the bond market. However, given the relative outperformance of Non-Agency RMBS, we would prefer to add risk at the margin elsewhere when the appropriate time comes.
Credit is cheap. We anticipate default rates in non-financial corporations to be very low by historical standards compared to previous weak economic times. The main risk is that there is further mark-to-market pain to come and valuations could easily overshoot to extreme levels. We therefore retain various credit hedges in the Fund and are saving our risk budget for now. We believe the sovereign crisis has to get worse before it can better. However, with a lot of bad news already factored in to corporate bonds, the time to start buying is undoubtedly approaching.
Phil Milburn is a fixed income manager at Kames Capital.