Emerging Market Debt Appears Poised for a Revival
The big yield advantage they enjoyed over developed countries’ debt issues has narrowed, but EM paper retains other pluses.
Love me, love me not—love me again? Emerging market bonds were an institutional investors’ delight for a long time, then fell out of favor last year amid rising interest rates for Treasurys and other less-risky debt.
But now EM sovereign bonds appear ready for a rebound, as the Federal Reserve, having hiked its benchmark rate 11 times since March 2022, has signaled it is almost done.
A year ago, asset allocators’ lack of interest in EM debt was palpable, says Jim Craige, co-CIO and head of emerging markets at Stone Harbor Investment Partners. “Then, two quarters ago, the narrative changed” as the Fed hinted at an end point, Craige recounts, and investors began to place orders for the bonds again. “My phone calls get answered now.”
When most rates were near zero, EM paper paying high-single-digit returns had an overwhelming appeal. Today, the average yield for EM bonds is around 7%. Short-term Treasurys, always touted as “risk-free,” pay 5.5%. The J.P. Morgan Emerging Markets Bond Index lost 18.6% last year and in 2023 has crept up 2.5%.
Since the default rate for emerging market bonds is only 0.6% of global public debt, per the Bank of Canada, a worldwide recession could hike that to an uncomfortable level. In 2020, defaults hit 8%, including the likes of Zambia and Argentina. Nowadays, though, emerging nations are on firmer financial footing than they were just a few years ago. Half of them are investment grade, whereas a decade ago, very few were.
EM yields vary, although most offer investors better returns than U.S. Treasurys. Indonesia, rated BBB, offers a 6.4% yield on its 10-year sovereign bond. Mexico, also at BBB, pays 9.4%. The immediate difference seems to be that Indonesia’s central bank has stopped raising rates, and the more inflation-minded Mexican monetary authorities have continued to tighten. The 10-year U.S. Treasury yield is 4.3%.
Emerging Advantages
The expected end of Fed rate increases, along with projections that they will reverse course next year, is a boon for EMs. “Stable is better than rising,” says Henry Greene, an investment strategist at asset manager KraneShares, about the anticipated leveling off of Treasury yields.
EM central banks have raised rates earlier than the Fed, which has helped support their currencies. Consider Chile, which had a bout of bad inflation thanks to a burst of government spending at the outset of the pandemic. Then its central bank boosted rates to 11.25%, a move that pulled down the inflation rate—and strengthened the Chilean peso.
But Chile has now started cutting, although its yields are still relatively high, with its central bank dropping rates 100 basis points to 10.25% in July and expected to make a cut of 75 bps in September.
While the monetary tightening also reduced Chile’s economic growth, sending it into negative territory, there now are signs of a recovery, says Christine Reed, a fixed-income analyst at investment manager Ninety One. Meanwhile, Chile, already the world’s biggest copper producer, is embarked on a campaign to export its abundant supplies of lithium, used in electric vehicle batteries. Chile, Reed says, “is one of the biggest turnaround stories.”
In addition to yields, investors lately are focused on the twin beneficial influences of foreign exchange shifts, namely a weakening of the once-surging dollar, and high duration values for EM bonds, which would benefit from a rate drop. “With the coupon [of EM bonds] not as attractive, the story is no longer income” as the prime appeal to investors, Greene observes. “It’s currency and duration [or greater exposure to interest rate risk].”
On currency, the thinking is that a decline of the U.S. dollar should help buoy EM debt prices, the value of which tends to be the inverse of the greenback. In 2022, the dollar surged in value against a basket of international currencies (which included four EMs: India, South Korea, Mexico and China) by 18.5% until mid-October, when it began to fall due to talk that the Federal Reserve was nearing the end of its interest hikes. Since the September 2022 peak, the buck is down 9.4% as of Friday’s close.
Upshot: Interest and capital gains on EM bonds would be magnified when translated into dollars, the most common denomination of international finance.
Duration, which measures how a bond’s price may change when interest rates rise or fall, is comparable for EM sovereign bonds and Treasurys, about a factor of seven, meaning if rates dropped by two percentage points, prices would jump by 14%.
The duration comparisons are better for EMs relative to corporate bonds. Duration in EM debt is almost twice that of U.S. high-yield junk bonds, the yields of which are on a par with those of emerging countries, writes Marcelo Assalin, head of the emerging markets debt team at investment bank William Blair & Co., in a research paper.
Investors’ View
Many asset allocators retain a positive view of EM debt. The California Public Employees’ Retirement System, as of June 2023, held a substantial position in the asset class, which it has been expanding. EM sovereign debt as of mid-year composed 5% of its assets, or $23 billion. CalPERS would not specify numerically how that compared to the past.
To be sure, some public pension plans still are reducing their exposure to EM debt. The Connecticut Retirement Plans & Trust Funds, which had $1.7 billion committed to EM debt, or 4% of assets, confirmed it has whittled that down to 1% over the past six months.
Institutions “have rate hurdles”—yield levels they look for when buying a bond—and EM debt can easily clear them, in the view of Ayman Ahmed, a portfolio manager for global fixed income at Thornburg Investment Management. He advises being selective in choosing EM, saying, “You can pick up less-risky bonds and still get good returns.”
EM corporate bonds are, of course, further out on the risk curve than government debt, which is supported by taxpayers. So these companies offer an even richer yield.
Case in point: Pemex, Mexico’s state-owned oil company, periodically gets an infusion of government money, which suggests it is not about to become insolvent. Officially known as Petróleos Mexicanos, the business has a junk-level B+ rating, owing to its heavy debt load. And Pemex’s bonds pay a 12.2% yield, some three percentage points higher than the Mexican government’s payout on its own debt.
Debt Dynamics
EM debt’s retrenchment last year was sharp: Investors pulled $110 billion out of the sector’s mutual and exchange-traded funds in 2022, stats from research firm EPFR show. In 2023 through August 14, the outflow had slowed to just $1.8 billion. (The total for all funds is $655 billion.)
The 2022 investor flight was in anticipation of a tapering off of EM economic growth, which started this year. EM growth still is superior to that of developed nations. The problem for investors is that the difference between EMs and developed countries has narrowed. The gross domestic product of developed nations grew 2.5% in 2022 while EM economies, excluding China, climbed 4.1%. Nonetheless, the EMs are predicted to expand 2.9% by year-end 2023, per the World Bank’s mid-year outlook.
The forecasted EM growth slowdown is “due to the drag from high inflation and the associated monetary tightening—both domestically and via monetary policy spillovers from advanced economies—as well as from slowing external demand,” the bank’s analysis stated. Next year, the World Bank projects EM GDP growth to accelerate modestly to 3.4%.
In the long term, EMs still are growing faster than the developed world: Research firm World Economics calculates that emerging nations account for 66% of global GDP expansion. They have had an up-and-down history: a commodities spike in the 1970s that pushed them into too much debt to build out infrastructure, a U.S-led rescue in the 1980s under Treasury Secretary Nicholas Brady, a debt-fueled crisis in Southeast Asia in the 1990s touched off by a big fall of Thailand’s currency and an oil boom in the 1990s.
Today, many EM nations “are better diversified, and not dependent on just commodities and oil,” says Jeff Grills, head of emerging markets debt at Aegon Asset Management. Thailand, instigator of the 1990s crisis, now has an investment-grade BBB+ credit rating.
That could lead more allocators into EM debt. After all, as KraneShares’ Greene says, “emerging market bonds are back this year.”
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