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From Special Report:

Is it all over for emerging market bonds?

In spite of being the ‘must have’ asset class this year, emerging market (EM) bonds may have had their day, as spreads hit pre-Lehman lows.

By Jenny Lowe | Published Dec 20, 2012 | comments

According to Ashburton’s head of asset allocation Tristan Hanson, concerns over weak global growth and currency appreciation have dragged policy rates lower.

He explains: “Spreads on hard currency EM bonds are now approaching the pre-Lehman lows achieved during the mid-2000s credit bubble. In terms of local currency debt, real interest rates have collapsed in most EM countries, as concerns over weak global growth and currency appreciation have dragged policy rates lower.

“Low rates make EM bonds a riskier proposition going forward. Bond market performance may become more divergent and currency movements will likely become the dominant driver of returns.”

But Robert Abad, portfolio manager at Legg Mason subsidiary Western Asset, argues that EM bonds will be more attractive than equities in 2013.

“Sharp bouts of volatility stemming from US-, Europe- and China-related growth fears have helped to extend EM equities’ record of poor risk-adjusted returns relative to EM debt,” he says. “As a result, we are seeing more traditional holders of EM equity considering a partial or outright reallocation to sovereign and/or corporate credit.”

Investors have been flooding into the asset class, which is perceived to offer outperformance as a result of the region’s low debt levels, opportunities for growth and strong demographics.

For example, the Threadneedle Emerging Market Bond, managed by Henry Stipp, has witnessed the largest inflows from investors, with £51.8m invested in the past three months (September – November). M&G’s bond vigilante Mike Riddell made an apt comparison in saying: “EM debt is a bit like Converse shoes; it seems almost everyone I speak to owns some.”

So what are the major risks to EM debt? Mr Riddell awards China that prize. “The Chinese yuan has had the biggest drop against the US dollar since its big devaluation in 1994. I’m not saying that EM debt will never offer good value, it’s important to stress that there is no such thing as a good or bad asset class, only a good or bad valuation. It’s important to understand the performance characteristics of EM debt.”

Of the EM debt funds listed in the IMA fund universe, the best performing year to date is the Baring Emerging Markets Debt Local Currency fund with a return of 13.29 per cent to December 6. Conversley, the Schroder ISF Emerging Markets Debt Absolute Return fund has recorded a loss of 0.3 per cent over the same time period, according to FE Analytics.

With some major headwinds likely to have a effect on emerging market debt funds, Mr Hanson has a stark warning: “Global bond investors may need to tread carefully over the next year or two.”

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