Value vs. Growth Bondland?

Value vs. Growth Bondland? October 7, 2010, Peter Demirali, Vice President & Portfolio Manager

Analysts and investors often characterize stocks as having either growth or value characteristics. Growth stocks are generally companies whose shares are expected to grow their earnings faster than the overall market, while value stocks tend to trade at a lower price relative to fundamentals (i.e., dividends, earnings, sales, etc.).  From time to time, growth stocks seem to be undervalued.

We believe a similar case can be made in the bond market. Over the years we have seen growth-oriented characteristics in new fixed-income products like high-yield (junk) bonds, asset-backed securities (car loans, credit card receivables), and collateralized debt obligations (CDOs). Moreover, much like some fads in growth stocks, these sectors collapsed as they reached unsustainable levels and the underlying collateral became better understood by analysts.

In today’s market, we are seeing low yields on emerging-market debt. In our view, emerging-market debt is overpriced and exhibits growth-stock-type qualities. If you look at the yields on such debt, you see they are comparable to the yields on developed-country debt. Brazil’s ten-year debt currently trades at 3.67%, or a little more than 1 full percentage point above US Treasuries.

Brazil has a population of approximately 190 million and per-capita income of roughly $8000. Brazil has great prospects ahead of it. It has a large population and significant natural resources. However, it has had many periods in its history when it was not governed effectively or efficiently; thus there is a political risk for this country. Brazil does have an investment-grade rating, albeit the lowest (Baa3 by Moody’s and BBB- by Standard and Poor’s).

Another example is Mexico. Mexico has a GDP of about $1 trillion and per-capita income of $7800. The yield on Mexico’s ten-year debt is 3.59%. Mexico is dealing with a very difficult situation as it pertains to the drug trade. There is widespread criminal activity and corruption, which makes governing and adherence to the legal system an open question. Mexico has a rating of Baa1 by Moody’s and BBB by S&P. These countries, while experiencing faster economic growth rates, do not have the depth to withstand major disruptions to the global economy.  The Mexican peso crisis was only a decade and a half ago.

Contrast those yields with a sector of US debt where we see tremendous value: taxable municipal bonds of US state and local governments. This sector has started to gain traction with institutional and retail investors since the advent of the Build America Bond program (BABs) in 2009.

In today’s market, investors can purchase a nine-year bond issued by the Port of Seattle, a very strong AA credit, and pick up an extra 30 basis points in yield over a bond issued by Brazil. The Port Authority of New York and New Jersey offers yields 40 basis points higher than Brazil on a similar-maturity bond. The Port Authority of NY/NJ collects tolls and user fees on bridges, tunnels, airports, and piers in the New York Metro area. It has a credit rating of AA2/AA- by Moody’s and S&P.

In the same asset class, we see other issues of sovereign debt in the US.  Again, we are comparing against Brazil or Mexico.  Bonds issued by the States of California and Illinois offer more generous yields.  Their credit ratings are higher and the statistical basis suggests a much lower credit risk. California has a per-capita income of roughly $59,000/year; Illinois has a per-capita income of $54,000/year. While each of these states has its problems, they also have the resources to deal with them. This is why we believe they offer value in qualified plans like pension funds, endowments, and IRA rollovers, as well as sovereign wealth funds.

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