The developing world’s rapidly swelling corporate debt market is an accident waiting to happen, according to a prominent emerging-markets hedge fund that says a lack of liquidity could lead to violent 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 pull out money quickly.
“We are convinced 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 to happen.”
The emerging market corporate bond market has expanded nearly fourfold to $2.3tn over the past decade — with the high-yield sector expanding almost fivefold — as investors around the world have desperately sought higher-yielding debt.
At the same time, regulatory changes have forced banks’ trading desks to scale back their holdings, hampering their ability to cushion any turmoil. At just $16bn at the end of last year, the size of corporate debt inventories for primary dealers is just over 10 per cent 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 because of the regulatory environment in the post-2008 world, there are just fewer banks with less balance sheet . . . When that is tested, it is reasonable to expect it will fail,” Mr Koenigsberger said in an interview with the FT.
While EM corporate bonds are particularly prone to exaggerated sell-offs, all developing-world debt was now more vulnerable to the sudden evaporation of liquidity, Mr Koenigsberger added.
Gramercy, which has invested in emerging markets since 1998 and currently manages $5.3bn, has therefore purchased credit default swaps on emerging market government bonds — an insurance-like product designed to compensate investors in the event of defaults — in the expectation they will rise in value if there are sudden drops in EM asset prices.
Some of those CDS prices are the lowest since 2007, according to the group.
Others have noted the same risks in the EM debt universe. “It is much more dangerous now, but it is the new world and there is not much we can do about it,” said Alberto Bernal, chief emerging markets strategist at XP Investments.
A test will come when a lot of investors yank their money from funds at the same time, Mr Koenigsberger said. The trigger could be a rise in financial uncertainty — perhaps sparked by a recession — or a crisis in one country.
“When people wanted to get out of Argentina, Brazil, Turkey and Ukraine . . . there was no immediate buyer of last resort,” he said, referring to some recent examples. In these cases, bond prices fell sharply and suddenly, with little trading activity on the way down.
Gramercy and other investors agree that “dislocation” events could also offer up large returns, if trading is timed correctly.
Samy Muaddi, an emerging markets portfolio manager at T Rowe Price — which manages $7.5bn of EM corporate debt, of which $3.5bn is high yield — said that after Turkey’s currency crisis in 2018, he bought securities that plummeted to trade as low as 55 cents on the dollar. Now, some of those bonds trade near their face value.
“This is not a low-risk proposition,” said Mr Bernal at XP Investments. “A low-risk proposition is Denmark, and if you want to buy Denmark, there is no yield there.”