Fixed Income 

Buy EM inflation-linked bonds

Local currency emerging market inflation-linked debt in Poland and Israel looks attractive.

Fixed income investors are facing a challenging environment this year.

In the developed world, structural problems such as excessive debt and low growth rates are set to continue for some time.

In order to tackle these problems, central banks are keeping their interest rates at low levels and consequently, real yields for US, UK and German government bonds are negative, exposing bond investors to material losses of purchasing power.

As domestic economies and industrialised countries battle with this prolonged period of limited growth and debt, emerging markets have remained strong and are benefiting from good macroeconomic fundamentals, low leverage, policy reforms and consumer growth.

We believe that emerging market inflation-linked bonds represent an interesting investment opportunity. They offer real returns in the long run.

The debt fundamentals and growth prospects of emerging countries are sound and have attractive valuations. Currently, the real yield is above 2 per cent and the nominal yield is more than 7 per cent if the current inflation compensation of 5 per cent is included, making the asset class a compelling investment proposition.

The local bond markets offer an attractive level of steepness and yield pick-up. Currently, the implied yield in emerging market money markets (as measured by the Emerging Local Markets Plus index) is only roughly 2.9 per cent, while emerging market linkers offer yields of more than 7 per cent as outlined above. This pick-up is at the highest level seen in the past few years.

For investors willing to take exposure to local emerging markets, the bond markets offer more long-term return potential than pure foreign exchange or money market exposure.

Breakeven inflation rates are cheap and emerging market linkers are more attractive than conventional emerging market nominal bonds: during the weaker phase of economic cycles, the market often prices in a mild level of inflation for the years to come. This is good news for emerging market linker investors. They have the opportunity to lock in a compelling real yield by paying a cheap price to protect themselves against inflation spikes or rising inflation expectations.

To capitalise on this investment opportunity we seek compelling real yields coupled with solid debt fundamentals through an active investment process. From an interest rate perspective, in the past year, we have found this combination in countries such as Mexico, where we recently took profit and closed our overweight position.

Currently, we favour Poland linkers due to an attractive real yield level coupled with cheap breakeven inflation rates. We also like the long end of the real yield curve in Israel. In currency markets, a mix of attractive valuations and sound growth prospects can be found in the Mexican and Uruguayan peso.

Bernhard Urech is head of fixed income interest rates at Swiss & Global Asset Management