At the end of April, Bank of America (BAML) released the annual review of its bond indices for 2015. Given that it was only four years ago that BAML decided to include Emerging Market (EM) hard currency debt in the Global High Yield Index (HW00), we were very surprised to see that it is now considering pulling EM out of that index. At that time in 2011, we praised the inclusion of EM debt in HW00 as prescient because by including EM debt in the global bond index BAML acknowledged the truth that the globalisation of credit is here to stay. And, as the investment consultant Russell Investments concluded in a market thought piece in April 2013, “we prefer to invest where we believe the market is going, rather than where it has been.” As such, it would be a mistake for BAML to reverse the decision it made a mere four years ago simply because “a number of high profile emerging markets corporate downgrades – including PETBRA, currently the largest name in HW00, and a large contingent of Russian corporates – have refocused attention on this particular aspect of the index rules”.
We fail to see the logic that BAML cites for the reason it is considering the change. It makes no sense to acknowledge the increasingly global nature of high yield credit in 2011 and then to reverse course simply because some managers’ expectations failed to consider the prospect that fallen angels could have a meaningful impact on the global high yield index. The fact is, the changing character of the index must reflect the changing character of global high yield credit. Just as the high yield indices reflected the impact of the move to high yield for large fallen angels such as Telecom Italia, ArcelorMittal, Centurylink, among others we believe that HW00 should do the same. Meantime, despite its large size in HW00, PDVSA has been in the index for years, and yet there has never been a question of its presence. Therefore to remove EM credit from HW00 simply because ““a number of high profile emerging markets corporate downgrades – including PETBRA, currently the largest name in HW00, and a large contingent of Russian corporates – have refocused attention on this particular aspect of the index rules” implies an inconsistent approach.
And, to those that take the view that the hard-currency credit from EM names is inappropriate because of the sovereign risk analysis involved, we would say that it is, in fact, no different than what is involved in investing in Greece today; both core and peripheral Europe during the debt crisis of 2011 and 2012 or even the UK during the recent elections. Note that during this European sovereign debt crisis Italian and Spain sovereign five-year CDS traded as wide as 600 basis points. France was as wide as 250 basis points, compared to its 35 basis points today. What were the recent wides for Brazil and Russia? 320 basis points and 630 basis points respectively. The point is the volume of sovereign risk that goes into investing in credit dials up and down depending on the ebb and flow of politics, economics and interest rate fluctuations across all jurisdictions - be they developed or emerging.
Beyond acknowledging the structural change in global credit markets, there are obvious benefits to the existence of a truly global index. First, it provides a reference for performance for those managers who believe, as we do, that managing on a global basis opens up new opportunities to deliver superior performance to clients by capturing valuation anomalies across the world, whilst at the same time avoiding having to be a forced buyer of one particular jurisdiction. Second, the prospect of investing globally allows investors to take full advantage of the benefits of diversification by region, sector and currency. Against a backdrop of reducing liquidity, global diversification provides a further risk control mechanism providing it is managed through a robust framework. Third, we, like many managers in the market, have built and are managing products around this exact change. To change the benchmark now would create superfluous disruption and moreover, it would disappoint existing and prospective investors of global credit products who actively seek this diversification.
Finally, from an ESG perspective, because investors in global, public markets have high expectations for corporate governance, the presence of EM companies in the global bond markets fosters the development of more open and transparent reporting and dialog with investors from these EM jurisdictions. And, we believe the presence of a truly global index can lower the cost of capital for issuers of hard currency debt from the EMs because it supports an active market place into which the companies can issue bonds. Both of these reduce cost of capital and volatility.
In summary, we encourage BAML to acknowledge the inexorable globalisation of credit markets and take the decision to keep EM hard currency debt in HW00.