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  • Emerging Markets Bonds

    The New Year May Bring Opportunities in Emerging Markets Bonds

    William Sokol, ETF Product Manager
    January 04, 2017
     

    The emerging markets bonds market has evolved significantly over the past two decades, growing in both size and diversity. The market's growth reflects the dynamic structural reforms that have transformed many emerging markets economies and helped boost economic growth. Also, investor understanding and appetite for emerging markets bonds has increased significantly as more investors recognize the asset class's potential income and diversification benefits.  

    In this five part blog series (read my previous post, Steady Climb of Emerging Markets Ratings Challenged in Recent Years), we advance the case for investing in emerging markets bonds and identify some of the potential opportunities the asset class may offer in today's market environment.  

    Current Opportunities in Emerging Markets Bonds

    We have previously discussed the tremendous diversity within the emerging markets bond market, the structural reforms many countries have undertaken, and the improving fundamental outlook (particularly versus most developed markets). Because of these factors, we believe there is a strong case for a strategic, long-term allocation to emerging markets bonds within a diversified portfolio.

    However, emerging markets asset classes can be significantly affected by changes in market sentiment, given their perceived risk. The selloff following Donald Trump’s surprise U.S. presidential win is a recent example of this type of activity. Following nine months of steady inflows into emerging markets bonds, as investors sought out attractive yields relative to the asset class’s improving outlook, in November investors pulled money out of emerging markets bonds amid speculation about what a Trump presidency might mean for developing markets.

    Be Opportunistic Amid the Volatility

    We believe that the long-term case for emerging markets bonds remains intact, but also expect volatility in the coming months until there is clarity on President-elect Trump's priorities and his ability to implement them. Periods of volatility may provide attractive entry points for investors to add exposure. In the near term, the sectors within emerging markets bonds may perform very differently based on how markets react to the new administration's first 100 days and beyond. Depending on an investor’s opinion of what may transpire, we believe the asset class offers several ways to express that view.

    Lift off - credit outperforms: The "Trump trade" has been characterized by higher interest rates across the curve and a stronger U.S. dollar due to expectations of accelerating growth and inflation. If this continues, credit sensitive asset classes such as high yield emerging markets corporate bonds may benefit. As of December 31, 2016, this sector provided a yield of 6.95%, a 78 basis points pickup over U.S. high yield corporate bonds (as measured by the BofA Merrill Lynch Diversified High Yield US Emerging Markets Corporate Plus Index and the BofA Merrill Lynch US High Yield Index), along with a shorter duration which generally reduces sensitivity to changes in interest rates.

    In addition, higher carry can provide a cushion that protects against rising interest rates, because it may compensate for the unrealized losses that result from rising interest rates more quickly than lower yielding bonds, all else being equal. For example, for a 1% rise in interest rates, investors in high yield emerging markets corporate bonds would recoup the resulting decline in market value in about 0.5 years, versus nearly two years in U.S. investment grade corporate bonds (as measured by the Bloomberg Barclays U.S. Corporate Bond Index), due to both higher carry and lower duration.

    Higher Carry = Shorter Breakeven Holding Periods

    Higher Carry = Shorter Breakeven Holding Periods

    Source: J.P. Morgan, BofA Merrill Lynch and Bloomberg. EM Local represented by the J.P. Morgan GBI-EM Global Diversified Index; HY EM Corporates represented by the BofA Merrill Lynch Diversified High Yield US Emerging Markets Corporate Plus Index; U.S. HY represented by the BofA Merrill Lynch US High Yield Index; IG Corp represented by Bloomberg Barclays U.S. Corporate Bond Index.

    An allocation into higher yielding fixed income sectors could therefore provide the ballast within a portfolio that core fixed income sectors may not provide in a rising rate environment. Although investors assume additional credit risk by moving into high yield bonds versus investment grade, this may prove to be a profitable trade if expectations of higher growth comes to fruition.

    Continued volatility - focus on quality: Higher quality assets may be more resilient in periods of market volatility. One area within emerging markets that may allow investors to be more defensive is U.S. dollar denominated investment grade sovereign emerging markets bonds. This sector may allow investors to avoid the volatility that can be associated with emerging markets local currencies, while maintaining high credit quality which may benefit investors if spreads begin to widen. Further, these bonds provide a significant yield advantage over other investment grade fixed income sectors such as U.S. corporate bonds.

    Yield Pickup versus Investment Grade Fixed Income
    as of 12/31/2016

    Yield Pickup vs. Investment Grade Fixed Income

    Source: J.P. Morgan, BofA Merrill Lynch and Bloomberg. EM IG USD Sovereigns represented by the investment grade subset of the J.P. Morgan EMBI Global Diversified Index; U.S. IG Corporates represented by Bloomberg Barclays U.S. Corporate Bond Index; U.S. Agg represented by the Bloomberg Barclays U.S. Aggregate Bond Index.

    Although these bonds may exhibit sensitivity to changes in interest rates, they could also benefit if rates retreat from their recent highs. This could occur if it appears that Trump may not be able to deliver on the growth-oriented agenda he has promised, resulting in lower inflation expectations.

    Market reversal - local currencies poised to benefit: Emerging markets local currencies have borne the brunt of the emerging markets selloff following the election. In addition to the significant appreciation in the U.S. dollar over the past few weeks, concerns about the impact of Trump's campaign proposal on specific countries, such as Mexico, have weighed on currency valuations. By historical measures, many emerging markets currencies were already cheap prior to the election, and since then have sunk to levels not seen since the financial crisis in early 2009. Given these levels, any sign that the Trump agenda (as it relates to emerging markets) has stalled, been sidetracked, or will be ineffective, may boost local currencies.

    Other items on Trump's agenda could benefit emerging markets local currencies. Much of the market impact from Trump's win has been attributed to expectations of an inflationary infrastructure spending program. Many emerging markets currencies are closely linked to commodity prices, which could benefit under this scenario. In addition, the recent OPEC (Organization of Petroleum Exporting Countries) production deal may keep oil prices higher, helping to support the currencies of oil exporters such as Russia, Colombia, and even Mexico.

    EM FX versus Commodity Prices
    January 2011 – December 2016

    EM FX vs. Commodity Prices

    Source: Bloomberg and J.P. Morgan. Commodity Prices represented by Bloomberg Commodity Index. EM Currencies represented by the currency return index of the J.P. Morgan GBI-EM Global Diversified Index. Past performance is no guarantee of future results.

    Low visibility - hold the entire market: The effects of Trump's win, and more broadly, changes in economic and geopolitical outlooks, tend to impact the various sectors within emerging markets bonds differently. For example, local currency bonds have recently exhibited larger drawdowns versus hard currency bonds, while corporate bonds have outperformed as tighter spreads offset the impact of higher interest rates. Deciding where to allocate within emerging markets bonds is an active decision that can significantly affect an investor's risk/return profile, and given the lack of clarity that currently exists, this can be extremely challenging. As an alternative, investors may prefer to have broad beta exposure to the entire emerging markets bonds opportunity set, and potentially benefit from the inherent diversification within the asset class.

    In the final post of this series, we will examine the performance characteristics and the potential benefits of investing in emerging markets bonds from a portfolio construction perspective.