Returns from bond funds outside developed markets stand out, but as the crisis in Argentina has shown, setbacks can be savage.
The Investment Association’s global emerging market bond fund sector – which was split off as a separate category in 2015 for funds investing at least 80 per cent in emerging market bonds – has become a very mixed bag of funds specialising variously in hard currency, local currency and corporate bonds.
Historically, most institutional investors allocated their exposure to sovereign bonds, which tended to be dollar-denominated. However, as the market has matured, ‘higher-quality’ developing nations have issued a greater amount of sovereign bonds in their local currency, opening up a range of investment choices. At the same time, these countries have been expanding their markets in corporate bonds, which are typically dollar-denominated and therefore do not carry the forex risk of local currency.
This trend means that in the emerging market bond space, sovereign bonds are more volatile than corporate bonds, because sovereigns are increasingly issued in local currency that carries exchange rate risk, while corporate bonds tend to be issued in dollars by large and established companies with sizeable funding requirements. Furthermore, corporate bonds have a typical duration of 5-10 years, whereas sovereigns have a duration of 10-30 years, so the latter are more vulnerable when economic expectations worsen.
Plenty of value
Emerging market corporate bonds still carry their traditional risks relative to developed markets, such as a lack of transparency and weak corporate governance, but many emerging market corporates are part-owned by governments, so they have a certain level of support, and overall levels of leverage are lower than for comparable developed market corporates.
Currently, yields on emerging market debt are in mid-single digits, and spreads – the comparison between the interest a bond pays and that from a Treasury bond of the same maturity, which indicates the level of concern about a borrower’s ability to service its debt – are expected to remain broadly stable. However, when headwinds occur, price action in this market can be brutal, with sharp falls. The strength of the dollar since April has been a timely reminder of this, with bonds giving back some of their solid gains from 2017.
Nonetheless, the consensus among fund managers is that there is value to be found in the asset class, reflecting attractive long-term fundamentals.
Mike Hugman, co-manager of the Investec Emerging Markets Blended Debt fund, says: ‘It has been a challenging environment for emerging market bonds, given negative developments in markets such as Turkey and Argentina as well as ongoing headwinds of the US-China trade dispute and dollar liquidity tightening. In general, however, emerging market fundamentals are relatively good. The global economy is still growing well, and on aggregate, emerging markets are still early in the cycle, with plenty of slack in many economies and therefore room for growth to accelerate without stoking inflation or causing a deterioration in trade balances.’
Long-term, emerging market economic market growth is expected to hold up, and while it has suffered from comparisons with the US in recent months, that could change going into 2019 as the memory of loose fiscal policy in the US begins to fade.
‘Our view is that there is more value to be found in emerging bond markets,’ says Stuart Edwards, a global bond manager at Invesco Perpetual. ‘There is nervousness about US monetary policy, but generally, if someone is sanguine on global growth and not expecting sharp rate rises by the US Federal Reserve, there could be opportunities. Furthermore, expectations that the US will outstrip emerging markets in terms of growth potential could reverse in 2019, which would be helpful to the asset class.’
The biggest immediate risk to the growth outlook is the risk of a full-scale international trade war. US trade policy towards Europe and USMCA (formerly Nafta) is likely to be moderate, but questions remain over escalating tension with China.
Mary-Therese Barton, head of emerging debt at Pictet Asset Management, believes ‘the market is beginning to be able to see through trade tension headlines and focus on the repricing that has already occurred in emerging markets in light of the revision of the emerging market growth outlook’. She adds: ‘External financing needs have been in the spotlight, and rightly so, but for countries such as Argentina and Turkey, emerging market vulnerabilities are lower than in past episodes of financial market turbulence.’
Arguably, the recent rise in the yield on 10-year US Treasuries, which at 3.2 per cent is now at its highest since July 2011, is in agreement and shows that the investment community no longer feels compelled to flock to the safety of Treasuries, possibly because some of the trade war worries relating to Canada and Mexico have been ironed out.
Some managers have again been favouring hard currency over local currency emerging market debt, believing that the sell-off has reintroduced value into credit spreads, while local currency debt yields could be hampered by inflation, which is picking up in some markets as oil and food prices rise.
However, there remains much greater focus on country-specific stories and what fund managers call ‘bottom-up relative value trades’, which essentially means the attractiveness in terms of risk and reward of one sector or industry compared with another.
Another focus is ‘growth desynchronisation’ – as opposed to the growth synchronisation seen earlier in the year – which should provide opportunities for active managers who are able to differentiate between countries or industries with different fundamental outlooks and avoid those where the outlook is unfavourable.