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Rates are not the only bogeyman

Business person afraid of a big monster claw shadow concept

Credit risk always outpaces rates in emerging markets

The nature of the new Omicron variant of Covid-19 may remain a mystery for now, but the sell-off it has triggered in emerging markets has made at least one thing very clear: There are still risks — especially in EM — that have little to do with rising rates.

In the last few months, the hottest ticket in town has been high yielding EM paper, as bond investors have fretted over the prospect of rising US Treasury rates. The hope was that the chunky spreads on these bonds would make them better able to absorb Treasury volatility next year, that the high coupons being paid out would amply compensate for any loss in secondary trading, and that potential improvements in credit would outpace base rate rises.

Hands have been wrung over new issues losing half a point in the secondary market. Buying high yielding bonds was thought of as the panacea.

Some EM fund managers have confessed to having their heads turned by these high coupon bonds more or less exclusively because of the meaty yield, rather than because they had a clear view view on the credits.

That could be seen as lazy, but in some ways it is fair enough. You can only play the hand you are dealt.

But a move of a few basis points in Treasuries is small potatoes compared to what has happened this week, as the world faced the possibility of Omicron undermining Covid immunity. Some of those hairier, higher yielding bonds have sold off by 100bp.

And that was merely a nudge compared to the bloodbath in the Turkish lira last week and the accompanying 50bp widening in that country’s CDS.

It will surely pale in comparison to what will happen if the tension between Russia and Ukraine comes to a head and the west gets involved, slapping on more sanctions.

US Treasury yields are tighter this week, but EM portfolio managers are not celebrating. Global appetite for risk has taken a beating.

The Omicron sell-off is a timely reminder that an EM bond yield is made up of two components — the underlying rate and the credit spread. And it is the latter that tends to have more bite.

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