‘No Margin for Error’ Sparks Rush for Hedges in Emerging Bonds

rv}[7mf{pma08]]ez0n)bnx[_media_dl_1.png JPMorgan Chase & Co.

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(Bloomberg) — Strategists and investors are turning to hedging and relative-value trades as a rally in emerging-market bonds looks increasingly disconnected from the looming impact of the ongoing conflict in the Middle East. 

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JPMorgan Chase & Co. is telling clients to seek protection against potential losses in risk assets through a credit-default swap index, while Fidelity International and London-based hedge fund Frontier Road Limited are cutting or limiting their exposure to developing debt. At PPM America, managers are taking a more selective approach, targeting countries that may perform well regardless of how the war in Iran evolves. 

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The adjustments reflect a growing sense of unease among investors, many of whom question whether the rally in developing-world debt — clocking its 12th monthly gain in 13 — has gone too far. Spreads on emerging-market bonds have narrowed to near their lowest levels since 2013, extending gains even as the Iran conflict drags on and inflicts economic damage globally.

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“Prices are implying everything will be fine, and that could be true. But if it’s not, then the market’s probably wrong in a pretty material way,” said Matthew Graves, a portfolio manager at PPM. “There’s really no margin for error in prices.”

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Policymakers have grown more vocal about the risks tied to the conflict. Last week, the Federal Reserve’s split decision to hold interest rates showed a deepening division over the outlook amid the ongoing tensions. Officials in Chile and Thailand, who kept rates unchanged, also warned of impacts from the war, while Pakistan delivered a larger-than-expected hike amid disruptions to energy supplies. 

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The divergence is evident across asset classes. Equities in both emerging and developed markets have climbed to fresh highs even as the conflict persists, reinforcing that investors may be underpricing the risks.  

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“Credit spreads are holding firm — but don’t mistake resilience for safety,” said Ben Ramsey, head of emerging markets sovereign strategy at JPMorgan, in a note dated Apr. 28. “We think it is prudent to hedge the possibility of a jump higher in spreads.” 

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During the initial weeks of the ceasefire, fund managers like Aberdeen built up cash levels to create a buffer in anticipation of a breakdown in talks, according to emerging markets analyst Leo Morawiecki. But now, even as efforts to resume peace negotiations stalled, his team has slowly started deploying cash again. 

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Persistent high oil prices could provide opportunity for some developing nations exposed to energy. The likes of Martin Bercetche, a portfolio manager at Frontier Road, are sticking with credits including Venezuela and Ukraine corporates because they seem relatively uncorrelated to the broader market.

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Resilience Party

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Whether inflows into emerging-market debt funds pick up in the coming weeks may be key to determining if the rally can be sustained. Investors will also monitor the risk of a global or US recession if the conflict drags on. Iran delivered a new peace proposal to the US on Friday, while President Donald Trump vowed to maintain a naval blockade.