InvestmentsMar 2 2023

The role of emerging market bonds right now

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The role of emerging market bonds right now
(avanti_photo/Envato)

Fixed income markets endured a torrid 2022, with both government and developed market corporate bond markets enduring falls far sharper than those of equities.

And within that emerging market bonds suffered to an even greater extent, but with markets having rallied in 2023, many investors are generally more positive on risk assets and are grappling with the dilemma of how to get a worthwhile yield for income-focused clients in a world where inflation remains at double digit levels. 

Emerging market bonds had strong inflows in January as many investors reassessed the asset class.

The macro backdrop may also be more favourable to emerging markets as a whole, with dollar weakness and the re-opening of the Chinese economy possibly improving the ability of emerging market companies and countries to repay their debt.

Conversely, the stout rise in yields of developed market government and investment-grade bonds may mean investors no longer need to go out as far on the risk curve as emerging market debt.  

The main benefits are higher levels of income, potential for capital appreciation, and diversification.Denise Simon, Lazard

Denise Simon, managing director and portfolio manager, emerging markets debt, for Lazard Asset Management, says investors may tend to view fixed income assets generally as a form of protection from volatility in a portfolio, but when it comes to emerging market debt this is firmly in what she calls the “return seeking” part of the portfolio. 

By that she means it does not do the job traditionally associated with bonds in a portfolio as volatility is higher, but also that, in common with other highly volatile asset classes, emerging market bonds role in a portfolio is closer to that of equities, as the focus is on generating a return.

She says: “The main benefits are higher levels of income, potential for capital appreciation, and diversification. Thus, we believe emerging market debt should be included in the strategic allocation in a well-diversified portfolio.

"Emerging market debt suffered record outflows in 2022, so many investors are currently under-invested, but we’ve seen flows turn positive recently and expect this trajectory to accelerate as investors come to realise the current opportunity in emerging market debt and once again recognise the benefits of a strategic allocation.”

Tom Kynge, portfolio analyst at Sarasin and Partners, says he is now finding emerging market bonds to be more interesting, but that there are two considerations when choosing how to access the asset class. 

Denise Simon is managing director, portfolio manager, emerging markets debt, for Lazard Asset Management (Photo: Lazard)

The first is whether to invest in local currency debt (that is, get paid your coupon in the currency of the issuer and then exchange it into sterling) or stick to 'hard currency' bonds, that is, those which will repay the coupon, usually in dollars or Euros. 

The buyer of the bond is taking the risk with a local currency that it devalues relative to sterling and so the returns on the bond could be less than the loss on the currency.

Simon says the level of yield on a hard currency emerging market bond is closely linked to the yield on a US Treasury bond, but this relationship is inversely correlated – that is, if the price of US government debt is rising, in normal market conditions, the price of emerging market debt would be expected to fall. 

In that way, the asset classes are inversely correlated and so emerging market debt can be said to be a diversifier, at least in theory. 

And in practice, Simon says at the current pricing levels emerging market bonds can deliver returns similar to equities, but are sufficiently lowly priced that they could potentially have only the volatility level of bonds right now. 

Cash on the hip

The second related issue is around liquidity. The liquidity of the emerging market currency is obviously relevant, but then comes the issue of the liquidity of the bond – in normal times there would be less volume traded in emerging market local currency than in emerging market hard currency debt. 

Kynge says: “Our preference would be for emerging market government bonds denominated in local currency that have sufficient liquidity to allow for flexible trading. Our preference for liquidity at this stage relates to the uncertainty of global growth.

"In the event of a global recession, the US dollar’s role as the global reserve currency would likely lead to strengthening and, therefore, currency losses on emerging market currency bonds.”

 

Dimitry Griko, a specialist emerging market debt investor at Arkaim Advisors, says many parts of the emerging market corporate bond universe presently trade at prices below the 'recovery' level of the bonds, that is, the price of the bonds is presently lower than the cash a creditor could expect if the companies actually defaulted. 

Apart from valuation, his principal argument in favour of emerging market debt right now is that, in his view, the performance of the asset class is relatively uncorrelated with that of wider debt markets.

He adds that the outflows that were a feature of the sector in recent years have started to reverse, and if the sector begins to attract inflows, that is a positive both from the point of view of performance, and also of liquidity, as inflows mean there are more buyers than sellers.

Kevin Thozet, a member of the investment at Carmignac, says many emerging market central banks put interest rates up to combat inflation some time ago, and this means if they feel the need to stimulate economic growth, they have the capacity to cut interest rates.

A central bank cutting rates would normally be expected to boost the price of the government bonds of that country, as future bonds will have an interest rate reflecting the new, lower base rate, while the bonds already in issue will have an interest rate that reflects the previous, higher interest rates.

Kunal Mehta, head of the fixed income product specialism team at Vanguard, says that trying to use economic trends to drive returns within an emerging markets bond allocation is likely to mean "greater volatility", and so he prefers to look at traditional, technical factors in the bond market such as duration as a way to gain returns above those offered by the market. 

David Thorpe is investment editor at FTAdviser