Is Emerging Market Debt Still Worth the Risk?

Diversifying into emerging market debt may not be as straightforward as some would have you believe.

Investors turning to emerging market debt to diversify their fixed income portfolios could be taking on additional—and unrewarded—risks, a fund manager has warned.

HSBC Global Asset Management’s (HSBC GAM) emerging market fixed income team voiced concern over some areas of the asset class, including illiquid “frontier” debt and corporate issuers.

“If there is a correction in emerging markets—which we are anticipating—corporate debt will be hit hardest.” —Brian Dunnett, HSBC GAMBrian Dunnett, fixed income product specialist at HSBC GAM, said spreads in the emerging market debt sector were “historically tight”, leaving several countries vulnerable to a sell-off when the Federal Reserve begins to raise the US base interest rate. Many small, illiquid sovereign bond issuances were trading “at or above par”, Dunnett said, meaning valuations were not compensating investors for credit or liquidity risks.

It was a similar story in corporate debt, Dunnett added, with emerging market corporate bonds trading significantly below their historic trend versus sovereigns. The spread above US corporate bonds was also near historic lows, he said.

“If there is a correction in emerging markets—which we are anticipating—corporate debt will be hit hardest,” Dunnett added. “You can get that extra yield, but given the fundamentals it is not an attractive prospect right now.”

The warning follows similar downbeat fixed income forecasts from ratings agencies Fitch and Moody’s in recent weeks.

A research note from Fitch Ratings said European fixed income funds may be tempted to overreach in an effort to boost yields, “potentially loosening selectivity in credit and leading to excessive risk taking”.

Moody’s highlighted that some large emerging markets—including Brazil, Turkey, and South Africa—“look challenged” by the prospect of higher US interest rates.

The yield on Germany’s two-year government bonds has fallen into negative territory over the past 12 months to -0.22%, while five-year German bonds yield only 0.05%, according to Bloomberg data.

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