PIMCO: Mix Up Your Bond Holding to Take Full Advantage

Investors should find potential in tactical exposure to the emerging market corporate sector, especially to quasi-sovereigns, within emerging market sovereign bond portfolios, according to PIMCO.

(October 29, 2012) — Emerging market corporate debt can add value to sovereign portfolios, according to the Pacific Investment Management Company (PIMCO).

At the same time, the supply of US dollar-denominated emerging market sovereign debt is decreasing and yields are near historical lows, Ignacio Sosa and Anton Dombrovsky of PIMCO write in the report.

‘How big is the EM corporate bond market?’, the paper asks. The answer is: big. According to the authors, the stock of emerging market corporate bonds outstanding has grown to around US$1 trillion, dwarfing that of EM sovereigns at $680 billion. “Moreover, in August the market capitalization of J.P. Morgan’s EM corporate debt index, the CEMBI Broad, surpassed that of J.P. Morgan’s EM sovereign debt index, the EMBI Global ($466 billion vs. $457 billion). New issuance by EM sovereigns in September put the market capitalization of the EMBIG back on top ($555 billion vs. $538 billion for the CEMBI Broad), but the trend toward greater issuance by EM corporates relative to EM sovereigns remains intact,” the authors assert.

Another question PIMCO’s research poses: How can emerging market corporates add value to emerging market sovereign portfolios?

The bond manager believes that emerging market corporates, especially quasi-sovereigns, can add value to emerging market sovereign portfolios in a variety of ways. The ways include, for one, higher yields.

Emerging market corporates can also be used to replace emerging market sovereign bonds issued by countries that a portfolio manager no longer wants in the portfolio – including sovereign bonds with solid fundamentals but less attractive risk-adjusted yields. “This is not uncommon with EM countries that have a weighting of 0.50% or less in the EMBI indexes: Because supply is limited, investors aiming to replicate an index may pay ‘scarcity’ premiums for the bonds, and risk-adjusted yields may become unattractive.”

The report concludes: “As the emerging market debt asset class evolves, we believe investors with EM sovereign bond portfolios can benefit from moving beyond their benchmarks to take advantage of tactical opportunities in the corporate sector. In our view, EM corporates, especially quasi-sovereigns, can help improve yields and reduce duration risk in EM sovereign portfolios at a time when US interest rates are close to historical lows.”

In contrast, the head of the United Kingdom’s professional actuarial body has suspected that defined benefit pension funds have moved too far out of equities in a bid to diversify. Philip Scott, who has been president of the organization since June this year, said he thinks the financial situation has changed and pension funds wanting to make up deficits and earn well balanced risk/return trades offs need to look back to stocks.

“We used to think equities yielded less than gilts – that reversed some time ago,” he said in October. “At what point will these low government bond yields come back? We don’t know, but has equity divestment gone too far? Yes, I think so. And it might be time to go back into to stocks,” Scott told aiCIO. Scott, a former equities and bond fund manager, said pension funds should be considering the returns they are getting on assets and look forward to where they might be in the near future.