After many years of stagnation, emerging markets finally witnessed a return to form in 2016. In what was a rampant period for equity markets in general, emerging world performance was nonetheless head and shoulders above a number of developed countries. Just as equities were able to shrug off political risk, so too did emerging market bonds emerge relatively unscathed from the election of a US president promising more aggressive trade policies.
Emerging markets, specifically China, had enjoyed a rich period of growth in the previous decade, with many investors enjoying spectacular returns as a result. But that went into reverse from 2013 onwards as the Bric nations – particularly Brazil, Russia and China – experienced a variety of economic difficulties.
That was until 2016, where a rebound for Brazil and Russia in particular helped restore confidence in emerging markets. Emerging market bond investors tend to have a slightly different investment focus – bonds issued by corporates and countries from around the world rather than relying heavily on the Bric nations – but they too saw returns improve.
Emerging market debt (EMD) has been a niche asset class for retail investors for many years, but it is starting to become more prominent. The creation of the Investment Association’s Global Emerging Markets Bond sector in 2014 was the latest evidence that the area is edging its way into the mainstream.
At a time of low yields globally, the rates of interest on offer from EMD have also become more attractive, even though this is a reflection of the increased likelihood of default for such bonds.
Booming bonds
The good news for the asset class has continued this year: statistics suggest bond sales in the developing world are booming. According to data from research firm Dealogic, emerging market countries sold record levels of sovereign debt during the first quarter of this year, equivalent to almost $70bn (£54m). Impressively, this was a 48 per cent uptick from last year and the highest amount ever for a single quarter.
Regionally, Africa, eastern Europe and the Middle East garnered the most interest, accounting for $39.1bn in sovereign bonds. The Americas and Asia proved to be less popular, attracting sales of $22bn and $8.4bn, respectively.
To add further weight to this trend, the turn of the year has seen healthy inflows into emerging market bond funds. According to data from the Investment Association, a total of £266m poured into the sector from January to March, making it the second most popular fixed income sector so far during 2017, lagging only Sterling Strategic Bond funds, which have attracted net sales of £714m.
By contrast, the final quarter of 2016 had seen £340m leave the EMD sector as investors briefly grew nervous over the impact of president Donald Trump’s policies.
Performance
Under Investment Association rules, to qualify for the Global Emerging Markets Bond sector, funds must invest at least 80 per cent of their assets in EMD as defined by a recognised Global Emerging Markets Bond index. In addition, they must be diversified by geographical region.
Historically, Asia has been a particular hub for emerging market equity managers. As mentioned, it is a slightly different story for bond investors, with Eastern Europe, Middle East and Latin America among the main areas of focus.
The top 20 performing funds over a period of five years can be found in Table 1. Overall, emerging markets bonds have struggled during this period when compared to both equity and other bond sectors. According to FE Trustnet, the sector is ranked 34 out of 38 over that period, outperforming only the UK Gilts, Targeted Absolute Return, Money Market and Short Term Money Market sectors.
However, performance over the past year offers more encouragement. As the data shows, the average fund has witnessed growth of 17.2 per cent in the past 12 months, aided by sterling weakness, meaning UK Index Linked Gilts is the only bond sector to outperform its emerging market counterpart.
But it should also be noted that average fund has dropped by 0.1 per cent since December, suggesting that the resurgence might prove short-lived.
When analysing how managers have fared against their peers the results reveal a large disparity, even in the top 20 funds. The best performer: BNY Mellon’s Emerging Markets Corporate Debt fund, has surpassed all others over both three and five years. It is only one of two funds, the other being M&G’s Emerging Markets Bond fund, averaging double figures for annual returns over five years. Growth of 11.7 per cent pa has far exceeded the sector average of 4.9 per cent, with 16.4 per cent achieved over three years against an average of 8 per cent.
As indicated, returns from the past year have been the most fruitful, but in truth, the BNY Mellon fund’s success has largely been due to outperforming the sector average in each of the five-year periods. This is particularly evident from 2014-15 and 2015-16, where returns of 15.6 per cent and 10 per cent trumped the sector averages of 4.3 per cent and 2.8 per cent.
Delving into the fund’s underlying investments shows the diversification strategy that most EMD funds employ in a bid to mitigate the risks of the asset class. The fund’s highest allocation is to Middle East and Russian debt – both at 10.3 per cent. The former exposure is to bonds issued by members of the Gulf Cooporation Council, which consists of oil-rich countries such as Kuwait, Qatar and the UAE. Otherwise, more familiar regions from an equity perspective also have a place. The fund has a 9.5 per cent weighting in China, with American emerging markets (10 per cent) and Brazil (8.7 per cent) forming a reasonable proportion of the portfolio.
Given the sway towards Russia and the Gulf nations, the fund’s 19.7 per cent exposure to the oil and gas sector is unsurprising. There are also sizeable allocations in the financial (18.1 per cent), technology (16 per cent) and consumer (12.7 per cent) sectors.
At the other end of table, positive returns have been more difficult to come by. Baring’s Emerging Markets Debt fund, while better than more than half of the sector’s 44 funds, has only managed to post a positive return in two of the past five years. As a sign of how varied the sector performance has been, its five-year annual compound growth rate is below the sector average despite its inclusion in the top-20 list.
China slowdown?
The recent uptick in emerging markets has restored confidence, but more recent news flow has reintroduced an element of uncertainty. Recent data has renewed fears of a serious slowdown in China. After a strong and encouraging first quarter the world’s second largest global economy has witnessed a change in fortunes. One sign was the news that industrial production had fallen in April to 6.5 per cent – some 1.1 per cent lower than the previous month.
The worry is that the stimulus programme that was unleashed at the start of 2016 is now at an end, raising the question of what happens when credit is tightened.
Furthermore, the country’s total debt to GDP ratio has a rather concerning trajectory, having risen to nearly 300 per cent. This figure was just over 250 per cent in 2014. Chinese debt is not a feature of most EMD funds, but its economic links with the rest of the emerging market universe means its fortunes have implications for those portfolios nonetheless.
Come what may, China will continue to exert an outsize influence on global markets – and its role in bond markets will increase, too. The country is forecast to account for a big chunk of global issuance over the coming decade – a fact that suggests it will gradually form a larger part of EMD portfolios.
The road ahead
Another nagging policy question for EMD is just what effect higher interest rates in the US will have on the asset class. In order to mitigate the impact of currency volatility, emerging market countries and companies often issue debt in US dollars. The downside of this tactic is that a stronger dollar means issuers’ liabilities increase.
As base rate increases tend to mean a currency increases in value, the US hiking cycle has put pressure on the asset class. So too has Donald Trump’s domestic agenda: policies to increase tax on imports would also affect emerging markets.
The counter-argument is that Mr Trump is already struggling to turn his words into actions. From a monetary policy perspective, EMD advocates suggest the US hikes planned for the rest of 2017 have been priced in, and add that the dollar has already risen as far as it can go. The recent dip for the currency, coming on the back of two years of soaring returns, would seem to add weight to this argument.
Of more concern for EMD funds would be the question of whether valuations have risen too far, too soon. The past five years may have been a volatile ride, but the gains made since 2016 have already pushed the asset class to unfamiliar levels.
As with other parts of the bond market, the traditionally high yields offered by EMD are not as large as they once were. Dollar-denominated corporate emerging market bonds now yield just 2.7 percentage points more than US Treasuries on average – down from 5.2 percentage points a year ago.
Advisers who are thinking the worst may be over for the asset class may want to consider whether the rally has now come and gone, too.
