"Emerging and submerging markets"

The recent fall in government bond yields (principally gilts) has renewed the search for alternatives and emerging markets are starting to receive the attention they deserve. One interesting development is the diverging path between corporate credit and emerging market sovereigns (see first chart). The principal reason is the outlook for default rates. The US high yield market has been dogged by outflows all year over fears that default rates are about to rise. Moodys (the rating agency) has consistently predicted a rise in default rates within the next three to six months. This has yet to occur, but with spreads so low, the fear is enough to push investors elsewhere. As we have argued in previous notes, the absolute level of spreads is low partly because the absolute level of government bond yields is low.

Emerging markets, on the other hand, have been receiving a great deal of flows, driving their spreads even lower. This support for emerging debt markets is fundamentally driven and should continue. For evidence of this desire for emerging market sovereigns then look at the recent bond issue by Iraq. It issued a 2028 maturity bond at a discount with a yield of +10% at the beginning of the month. In the past two weeks the bond has gone up 10 points and now yields 8.6%. Not bad for a country in turmoil, but it seems the longer the turmoil, the longer the US oversees the oil (revenue) flow.

The average credit quality of the high yield corporate bond has not changed much over the last 10 years, staying around B1. The average credit quality of an emerging market index has improved from B1 to BB2, which is only two stops away from the holy grail of investment grade. For those of you who are not familiar with these obscure classifications and, let's face it, that includes most, Moodys have downgraded General Motors from A2 in 1999 to B1 recently. Brazil has had its rating improved from B1 to Ba3 in 2004 and is therefore now a better credit than GM. This typifies the move up in sovereigns and down in corporates. This sovereign credit quality improvement was initially prompted by the Asian debt crisis of 1997. A direct result of that event was greater fiscal prudence and a desire to run current account surpluses. Cheap currencies were extremely helpful in this regard. This trend has been given an extra impetus by the price increases in commodities directly helping developing markets and hindering developed. The full effects of these trends are still feeding through to the balance sheets of emerging market sovereigns. Talking of balance sheets, corporates are not immune from these trends. The rise in commodity prices will eventually reduce margins and squeeze profits. With productivity gains and stable wages it can take up to two years for this to come through to corporate bond spreads, which means the second half of this year could be very interesting.

The following chart shows the gap between output prices and input prices in the UK. This production cost chart can be reproduced in most developed economies and shows the gradually increasing burden being placed on corporates. So far, increased productivity, low borrowing costs and stable or reduced wage bills offset the effects of higher raw material costs. So what is a gain for one type of risk asset is a loss for another.

Maybe Moodys' latest prediction of rising defaults towards the end of the year could be realised this time. But with long gilt yields nearly a full 1% below cash, the increasing hordes of bond investors have to diversify into riskier fixed income alternatives. Having the ability to switch between these assets in this low yielding environment is a must, as is the ability to spot credit opportunities. After all, not all companies will be equally affected. Another response to these pressures is to consolidate and use ample liquidity to buy other companies and then reduce costs. There are many high yielding corporates that fit this category.