Exotic Fixed Income

Prof. Davide Accomazzo

Email: davide@cervinocapital.com

In a universe of zero interest rates and demoted US Treasuries yielding negative real rates of returns (when accounting for inflation), the modern fixed income investor faces great challenges in order to capture reasonable risk adjusted yields.

In this piece we are going to take a look at two fixed income alternatives which are offering interesting possibilities in a field of disappearing opportunities: Emerging Market Corporates and Linkers also known in the US as Treasury Inflation Protected Securities (TIPS). 

Emerging Markets fixed income has normally been confined to Sovereign issues while the corporate sector was mostly localized and when offered to the international markets it was usually done via the institutional oriented EuroBond market and via small size issues.  However, EM Corporates are now an asset class that is coming of age in sync with the consistent growth of its underlying economies.  William Perry in the Journal of Indexes (September/October 2011 issue) highlights that the EM Corporate space has evolved from a market with a $20 billion in annual issuance volume to an average annual issuance in excess of $100 billion and a total outstanding size moving toward $1 trillion.

The growth of this asset class reflects the increasing economic power that emerging economies are yielding globally; in a world where developed economies are struggling with slowing GDPs and increasing debt burdens, the macroeconomic picture of developing markets is uncovering new opportunities.  As these economies develop, not only is their growth improving but so are their capital market structure and their legal framework; both elements help increase the value of Emerging Market Corporates.

Based on different macro metrics, it could be argued that the fundamentals of developing economies are indeed better than developed markets therefore a more significant allocation to EM Corporates may be where real opportunities lie.  One index that tries to replicate this new space is the Corporate Emerging Market Bond Index (CEMBI, William Perry in Journal of Indexes). This index reflects US denominated EM Corporates where Asia is represented at 41%, emerging Europe at 12.4%, Latin America at 28.47% and Middle East/Africa at 18.25%.

Another instrument with available global diversification and potentially more attractive real yields than traditional fixed income are Inflation Linked Bonds.  Such instruments are designed to guarantee investors a real rate of return regardless of inflation.  The coupon and the principal can be adjusted to deliver a real rate of return.  These are great tools for those investors that fear strong inflationary pressures may be the end result of our present fiscal and monetary policies.  Linkers are issued by governments around the world providing investors with a truly global menu; the US, Italy, Japan, France, the UK and most Emerging Economies are all large issuers of Linkers. 

One word of caution, especially for the retail investor, is the different characteristics of gaining exposure via individual Linkers or funds.  A typical fund will target a constant duration which may or not (unless the exposure is actively managed by the individual investor) be the best approach to match the investor’s future liabilities. Also funds (such as ETFs) could become overbought or oversold depending on market sentiment distorting the ultimate total return to the investor and potentially negating the sought after inflation protection.

 Contact details: davide@cervinocapital.com