Bond Bubble is Ugly, But Worst in BRIC

The fixed income financial markets have been as exciting as ever. Central bank action is leaving the profits thin, but traders who hold pre-financial crisis fixed income investments, especially in long bonds, are doing better than ever. Lower yields on bonds, due to their inverse properties, mean higher prices.

To keep enough powder dry for new opportunities is an essential element to international investment strategy.

Part of the problem is the comparative advantage of emerging market investments. For one, interest rates are significantly higher than in the developed world, and the credit rating of many corporations and emerging market governments has improved with time.

In addition, just as a stock might rise in value as it is added to the S&P500, for example, fixed income often rises in value as it reaches a new rating level. This effect is more noticeable with available risk capital at its lowest levels, as investors push cash into the safest asset classes. With each step up the inverse risk pyramid is even more cash waiting for performing debt obligations, along with lower expectations for yields, and thus, higher bond prices.

A Systemic Situation

The bond bubble is not a wholly emerging market event, but the emerging markets are where it is most obvious. Falling currency values in the developed world, combined with exceptionally low interest rates, bring an excellent carry trade opportunity for the developed markets at the expense of inflation in the emerging markets. To solve this issue, central banks will have to cut down bond investors from within their own borders, pushing up rates and driving down bond values.

Higher rates mean lower bond prices, paper losses, and very little exit strategy. However, worst of all, investors buying long bonds aren’t seeing the rewards of what they’re financing. 

Brazil is using excess cash for investment in state-run companies, Russia plans to invest in new roads and infrastructure, and India is preparing for a historic expansion of public infrastructure, including roads, telecommunications development and utility spending. For the most part, Chinese government spending is to remain flat.

Therefore, if investors are to dedicate their cash to these popular BRIC countries, they would be largely financing public-sector investment for private sector growth. In return, emerging market investors get some downside protection, reasonable yields, and dollar diversification. However, the upside is largely limited to changes in monetary policy, not economic growth.

The safer, and perhaps more rewarding, fixed income investment is located right in the middle of the developed world in solid, blue chip dividend stocks. An uptick in growth means better growth, as well as an expansion in earnings multiples and a drop in dividend yields for short term profits. Growth in the emerging markets, however, means falling bond prices, rising yields, and a locked-in trade.

One of the most important elements to international investment strategy is keeping enough powder dry for new opportunities. Not only do developed dividend payers offer yields, but they offer some downside protection, and most importantly, protection from rising central bank activity in the emerging markets. Plus, with most investors already holding at least some developed world assets, such a portfolio rebalance can be done without changing net investment in each geographical area.

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