After a volatile 2018 and a strong rally in early 2019 driven by renewed capital flows into emerging-market bonds, it is sensible to ask whether now is still a good time to invest in these markets.
The answer appears to be yes. Although spreads have narrowed in early 2019, the carry offered by emerging-market bonds and their intrinsic characteristics mean that they still represent an attractive investment opportunity for any investors wanting to diversify their bond portfolios while achieving returns that still show relatively good potential.
What are the factors likely to support emerging bonds in the next few months? Firstly, monetary tightening by the US Federal Reserve (Fed) is likely to come to a halt. The US economic slowdown is starting to have an impact, and the Fed itself has said that it intends to be “patient”. As a result, we are likely to see the Fed funds rate increased only once in 2019, or perhaps not at all, as opposed to the four hikes seen in 2018 and the nine that have taken place since the normalisation process began. Similarly, any increase in long yields is likely to be limited because, although US inflation has risen and is now close to the Fed’s 2% target, the slowing economy should prevent it from overshooting. As a result, the dollar’s strength is likely to fade, which will benefit emerging-market bond issuers by making their USD-denominated debt less costly.
Another positive factor for emerging bonds is that the growth gap between the developed world and emerging-market countries is set to continue widening, and this will naturally attract capital to emerging markets.
While economic activity is slowing in Europe and the USA, emerging-market growth should remain relatively stable: an acceleration in Latin America and Africa should offset the slowdown expected in China, and that slowdown should itself be limited by the various fiscal and monetary measures adopted by Beijing.
China and the USA are expected to sign a relatively pragmatic trade agreement, which should help emerging markets by mitigating any risk of a sharp drop in global trade. Commodity markets are also set to benefit from this environment: oil and base metal prices are likely to stabilise at current levels after rising sharply in early 2019, and they could increase slightly by the end of the year. This would further assist emerging-market issuers, which are dependent on these commodities to a large extent.
Finally, following uncertainty about the outcome of elections in several large emerging-market countries in 2018, there seems to be less political risk in 2019.
Elections in India and Indonesia are unlikely to derail the reforms taking place in those countries. In Argentina, there is no clear favourite to win the presidential election due to take place in the fourth quarter of 2019, but the IMF loan programme should arrest the decline in the peso and thus reduce inflation expectations.
This should result in lower interest rates and prevent a populist candidate becoming president. South Africa’s elections are causing us the most unease, because a narrow victory for the African National Congress would undermine the legitimacy of its current leader Cyril Ramaphosa. However, there is little risk that these elections will create a contagion effect across the whole asset class.
So while emerging-market debt seems promising, investors need to choose between three separate segments of the market: local-currency sovereign debt, or sovereign or corporate debt denominated in hard currencies (mainly USD).
Local-currency debt should benefit from the dollar’s likely decline against emerging-market currencies. However, that segment shows little diversification and is relatively volatile. Accordingly, it should only be considered by investors with a relatively high risk appetite and the flexibility to take tactical short-term positions.
Hard-currency debt, meanwhile, is less volatile and investors can take a more strategic approach, making it a core component of their bond portfolios.
At the end of February, the average yield on dollar-denominated emerging-market sovereign bonds was 6.1%, while emerging-market corporate bonds were yielding 5.3%. That gap may seem large, but it reflects substantial differences in risk between the two segments. Firstly, as regards interest-rate risk, emerging sovereign bonds show average duration of 6.8 years, while for emerging corporate bonds it is only 4.5 years. Credit risk levels also differ: emerging sovereign bonds have an average rating of BB+, which is in the “high yield” category, while emerging corporate bonds have an average rating of BBB-, which falls in the “investment-grade” category.
Historically, those differences have caused emerging corporate bonds to deliver lower volatility and higher risk-adjusted returns. In the last five years, emerging corporate debt (in USD) has shown a Sharpe ratio of 0.93 (return of 4.9% and volatility of 4.1%), while emerging sovereign debt’s Sharpe ratio has been 0.78 (return of 5.4% and volatility of 5.5%). This is why USD-denominated corporate debt remains the most attractive segment of the emerging bond market on a long-term view.
Senior Investment Specialist