Latin American yields fall further in a warning to bond investors

While the historic amount of quantitative easing enacted by the Federal Reserve may not be kick-starting the economy, it is definitely pushing investors to search for higher yields and riskier assets. High yield U.S. corporate debt has been the buzz for the last couple of years. It seems now those investors have been pushed further out to emerging market corporate debt.

According to the JP Morgan CEMBI Index, the average yield for the Latin American corporate debt is around 4.3%, just 165 basis points above investment-grade U.S. corporate debt. A Brazilian company, Cielo, issued debt recently at just 225 basis points above the comparable U.S. treasury debt, for a interest rate of 3.86%, the lowest ever for a Latin American company at that maturity.

This is a boon to corporations that have been able to access the market and now have ample liquidity for growth. Investors may want to reassess the environment, however. What was once an attractive risk-reward option for investors may be approaching an overpriced trap.

Most retail investors get their emerging market bond exposure through exchange traded funds that hold the debt and then pay a monthly or quarterly dividend. The funds have been gradually reducing their distributions as yields decrease and maturing debt is reinvested in more expensive bonds.

One of the best examples of this is the Market Vectors LatAm Aggregate Bond (BONO, quote). The fund paid its first distribution of $0.165 per share in July 2011, for a yield of 7.7% but has seen distributions fall steadily to just $0.108 per share for a yield of 4.2%. While demand for bonds has pushed the funds shares higher to a 10% return since May 2011, low yields and a shorter spread may mean limited appreciation from here on out.

The loss of yield is not exclusive to investments in Latin American corporate debt. The Morgan Stanley Emerging Markets (EDD, quote), a fund investing in sovereign and quasi-sovereign debt, paid an attractive 11.6% yield with its first distribution in 2007 but has since seen the yield fall to just 5.9% on a decrease in payment amount and rising share prices. The shares have returned 9.8% on an annualized basis over the last five years, but must now reinvest maturing bonds in an extremely low-yield environment.

Companies in the region generally have solid balance sheets with a low amount of debt so the bonds are relatively secure to maturity. This may be of little solace to investors that buy in at the height and then see their low yields eaten away when current rates increase and bond prices drop.

The saying goes, “Don’t fight the Fed,” and it is becoming increasingly relevant as investors get pushed further up the risk spectrum. When rates start increasing in the U.S. or if we experience another liquidity event, the bonds and the funds holding them are going to wipe out any marginal yield that might have been collected.

One Response to Latin American yields fall further in a warning to bond investors

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