Is Emerging Market Debt Leading Indicator for Risky Assets

While markets were close in the US on Monday, here is a report from Reuters that had not been widely noticed.

In the first week of the new year, investors put in an overwhelming $45 billion of bids for $1.75 billion of bonds offered by three junk-rated property firms from China.

But a more recent bond issue from Guangzhou R&F Properties was subscribed less than three times, while KWG Property withdrew its perpetual bond offering after it was covered just two times.

Only a little more than a week ago, on Jan 13, Agile Properties, a Hong Kong listed and Guangdong based Chinese real estate developer, brought to market a perpetual bond. The deal was originally marketed in the high 8% range, but it was 10 times oversubscribed and ultimate came in at 8.25%.

As central bankers of the world united in their quest to lower interest rate, fixed income investments of all grades have enjoyed dramatic rises over the past few years, none more spectacular than the ascension of speculative emerging market debt.

Perpetual bonds are a relative rarity in the world of fixed income investments, especially issued by non-investment grade companies. It carries the limited upside of fixed income investments, yet bears most of the total loss risk of equity investments. Moreover, if the issuer’s credit profile improves or interest rates become lower, the bonds will likely be called away and exposing investors to re-investment risk at the most inconvenient time. That is why the close cousin of perpetual bonds, the preferred stocks is mostly issued by highly rated banks and real estate investment trusts. While investors are still exposed to the interest rate risk, they can at least breathe easy on the credit front.

Pundits have rightly pointed out that the entire world of fixed income markets were in uncharted territory. From sovereign debts to junk bonds to emerging market papers, yields have all plunged and prices have all expanded awash in the nourishing succor of the central bankers. In such an environment, some have argued that investors might rotate out of fixed income securities and into equity investments. The sustained under performance of highly rated government securities must necessarily mean a rising rate environment. History and logic of asset valuation would suggest such milieu would not be conducive to the continued growth of equity prices. The calming of the junk bond froth, on the other hand, would suggest a heightened corporate default backdrop and weak economic condition. Such scenarios would seem equally harmful to stocks. While it is certainly possible for stocks to out gain bonds, it is rather implausible for stocks to advance while risky bonds decline.

In the event that the specter of fear returns to investors, all risky assets including stocks, emerging market debts and junk bonds will all be sold off. Even though Agile’s perpetual bonds came to market, unlike many other new issues, the price immediately sold off. Now investors have outright shunned the issuance of another perpetual, does that mean fear is in fact returning to emerging market debt investors? To paraphrase the words of Percy Shelley, could equities be far behind?