The elements driving emerging market yields

Rates that are too low can lead to the misallocation of cheap capital causing excessive levels of investment and asset bubbles. Rates that are too high could have the opposite effect of underinvestment and hence long-term costs to economic growth.

Historically this equilibrium has largely held in developed markets, however, in emerging markets the rule has consistently been broken. More recently though, yields have fallen across all markets raising concerns over the possibility of a new era of asset bubbles.

In an environment of positive economic growth, analysis shows that negative real yields are without doubt ‘unreal’ – there is no compensation for risk and capital could be better allocated to real assets. It is certainly right to question the current levels of real yields, especially in developed bond markets, as quantitative easing (QE) has distorted financial returns. But emerging markets, even recently, have been fortunate to also benefit from higher savings rates and falling credit and inflation risks. Policymakers should be vigilant to the risks of rising asset bubbles, and not squander the fruits of their policy improvements.

Analysis shows that real yields across emerging markets have fallen consistently since the financial crisis. At the end of 2007, the simple average real yield across the universe of emerging markets stood at 3.5 per cent. By the end of 2012 the average real rate was 1 per cent. The compensation investors received for taking on inflation risk (the risk that inflation turns out to be higher than expected), credit risk and currency volatility had fallen by a full 2.5 per cent.

The obvious conclusion is that the collapse in real rates has been caused by excessive global liquidity. QE in the developed world has trickled towards emerging markets.

The search for yield has lowered rates everywhere while inflation, for now, remains well contained – a consequence of excess global capacity and low consumption. Yet while it is accepted that excessively loose monetary policy has had a profound effect on global rates, there is more at play in emerging markets. You need only look back a few years prior to the financial crises to see why: real yields in emerging markets began to converge towards developed market real yields well before the advent of QE. Average real yields in emerging markets have fallen rather consistently since 2003.

Meanwhile in developed markets real yields have only fallen since 2008, and prior to this, real rates were relatively consistent, ranging between 1.5 per cent and 2.5 per cent.

In addition to the effects of excessive global liquidity there are at least four elements affecting real yields in emerging markets.

1. Higher domestic savings rates

Emerging markets, in particular Asia, experienced high rates of saving which allowed them to maintain low yields and fast growth without the detrimental effects of inflation. Higher savings rates depress real yields but encourage growth through higher levels of investment. This is a contradiction of the macroeconomic ‘rule’ mentioned earlier, that real rates should approximate economic growth.

2. Lower credit risk

Investors no longer require the same level of compensation for credit risk from emerging market sovereigns that they did 10 years ago. While the average credit rating of developed markets has fallen since the crisis, emerging market credit ratings have continued to improve on average – a trend that has been in place since the late 1990s. Real yields include a credit risk premium and as credit risks have fallen so has this premium.

3. A premium for inflation

As well as a credit risk premium, the real yields also incorporate a premium for the risk that inflation turns out to be higher than expected. Here too the premium has reduced. Nominal yields are made up of three components: a return to compensate for deferring consumption, a compensation for expected future inflation and a risk compensation for variations in either of the first two components.

4. Economic growth has been low

Growth in both developed and emerging markets is running below the levels experienced before the financial crisis. To stimulate their economies, central banks have cut policy rates and indicated that policies will remain accommodative for some time. This has not only caused short-term real yields to fall but also yields further along the yield curve.

Thanos Papasavvas is a strategist in Investec Asset Management’s fixed income and currency team