The booming corporate debt market in developing countries is an imminent crash, according to a major emerging markets hedge fund which says a lack of liquidity could lead to sharp price declines in a crisis.
In a letter to investors seen by the Financial Times, Gramercy Funds Management wrote that the risk of sudden dislocations has been increased by a wave of bond buying by mutual funds and exchange-traded funds that allow investors to withdraw money quickly.
“We believe that ‘liquid markets’ are not necessarily liquid,” Robert Koenigsberger, chief investment officer, wrote in a letter with senior adviser Mohamed El-Erian and two other associates of the Connecticut-based group. “The ‘Perfect Dislocation Storm’ [is] waiting for that to happen.
The emerging market corporate bond market nearly quadrupled to $2.3tn in the past decade – with the high-yield sector growing almost fivefold – as investors around the world desperately sought high-yielding debt higher.
At the same time, regulatory changes have forced banks’ trading desks to reduce their holdings, hampering their ability to weather the storm. At just $16 billion at the end of last year, the size of corporate debt stocks for primary traders is just over 10% of what it was in 2010, according to data compiled by Gramercy.
“The size of the market is bigger, the liquidity promise of the underlying vehicles has become much shorter and, due to the regulatory environment in the post-2008 world, there are just fewer banks with fewer balance sheets. . . . When this is tested it is reasonable to expect it to fail,” Mr Koenigsberger said in an interview with the FT.
While emerging market corporate bonds are particularly prone to exaggerated sell-offs, all developing country debt is now more vulnerable to sudden liquidity evaporation, Koenigsberger added.
Gramercy, which has invested in emerging markets since 1998 and currently manages $5.3 billion, therefore bought credit default swaps on emerging market government bonds – an insurance-like product designed to compensate investors. in the event of default – in the hope that they will increase in value if there are sudden drops in the prices of emerging market assets.
Some of these CDS prices are the lowest since 2007, according to the group.
Others have pointed to the same risks in the emerging debt universe. “It’s much more dangerous now, but it’s the new world and there’s not much we can do about it,” said Alberto Bernal, chief emerging markets strategist at XP Investments.
A test will come when many investors pull their money out of the funds at the same time, Koenigsberger said. The trigger could be an increase in financial uncertainty – perhaps triggered by a recession – or a crisis in a country.
“When people wanted to get out of Argentina, Brazil, Turkey and Ukraine. . . there was no immediate buyer as a last resort,” he said, referring to some recent examples. In these cases, bond prices fell sharply and suddenly, with little declining trading activity.
Gramercy and other investors agree that “dislocation” events could also offer significant returns, if trades are timed correctly.
Samy Muaddi, emerging markets portfolio manager at T Rowe Price – which manages $7.5 billion of emerging markets corporate debt, including $3.5 billion in high yield – said after the Turkey’s currency crisis in 2018, he had bought stocks that fell to trade as low as 55 cents on the dollar. Now, some of these bonds are trading near face value.
“It’s not a low-risk proposition,” said Mr. Bernal of XP Investments. “A low-risk proposition is Denmark, and if you want to buy Denmark, there’s no return there.”