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bond yields

With central bankers in Europe and Japan still pushing on the string with further rounds of quantitative easing, the hunt for yield remains the name of the game for institutional investors, who are looking to avoid the punishment of negative yields in their home markets.

With central bankers in Europe and Japan still pushing on the string with further rounds of quantitative easing, the hunt for yield remains the name of the game for institutional investors, who are looking to avoid the punishment of negative yields in their home markets.

The higher rates paid on emerging market sovereign debt is proving to be an irresistible lure for many investors. Over the course of the summer global bond funds have been steadily shifting allocations in their sovereign debt funds in order to increase holdings of emerging market issuers. The Financial Times described it as a massive flow of funds towards EM debt, including issuers such as Brazil, India, Indonesia and Argentina.

As Jack McIntyre, a portfolio manager for Legg Mason’s global bond fund explained current fixed income investor sentiment to the Wall Street Journal: “Which is riskier, buying a double-digit yielding sovereign bond or buying a negative yielding government bond? I’ll take the yield any day, knowing that there’ll be some volatility but knowing that over time you’re going to make a lot of money.”

Of course, global bond funds have been burned before by currency fluctuation, political and other macro risks that typically go along with the high yield on emerging market debt. As recently as last year, fixed income investors took a hit on emerging market debt when many emerging market currencies weakened by 15% or more in response to the business slowdown in China. But the lure of higher yields seems to be irresistible to fixed income investors facing the prospect of the negative rates.

Not all the money is flowing towards emerging market sovereigns. The U.S. bond market continues to remain a draw as safe haven for fixed income investors even in the face of uncertainty about the prospect of a further rate increase from the Federal Reserve before year’s end. Indeed, Wall Street’s biggest banks are expecting the Fed to raise interest rates once this year, and the increase would most likely occur in December according to the latest Reuters poll taken after the tepid August employment report quashed most talk of a move as early as this month.

But the attraction of U.S. Treasury debt to foreign investors has diminished sharply in recent months as yields have fallen to the point where net yield (after taking into consideration the cost of currency hedging) is approaching 0.0%. In the view of some market commentators, foreign fixed income investors, drawn to the U.S. for its safe haven status, have been rotating out of U.S. Treasury debt in favor of corporate debt from investment grade U.S. issuers, which looks highly favorable on a comparative yield basis to European or Japanese corporate debt. With this shift to corporate issuers, there has been a recent noticeable tightening in U.S. investment grade corporate debt.

So amidst the overall confusion and uncertainty as central bankers around the world experiment with negative yield, a basic pattern has emerged with fixed income investors being drawn both to the periphery, in pursuit of higher yielding emerging market debt, as well as to the center, in pursuit of relative safety in the U.S. market. If nothing else, it’s reassuring to see that the market continues to operate in accordance with a familiar logic, even as we tread into uncharted territory below the zero bound.

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