Catch Me If You Can: EM Bonds Outrun DM Peers
May 18, 2023
Read Time 3 MIN
Since March, investors have been reminded that financial sector stress is unique in its ability to impact broader markets, due to the risk of contagion, impact on the economy through credit availability, and potentially, the costs of a bailout. Such costs often historically have fallen on the public, and the impact to sovereign fiscal positions can be material. The failures of certain regional banks in the U.S., although they appear idiosyncratic and contained so far, have spooked domestic markets, but emerging markets (EM) have appeared insulated.
From a returns perspective, emerging markets local currency bonds have shrugged off these ongoing concerns, indicating that investors do not appear concerned about the banking systems in these countries. Returns have been driven by both local interest rates and currency appreciation, and have been broad based with 17 of the 20 countries in the J.P. Morgan GBI-EM Global Core Index posting positive gains through May 11, 2023.
EM Local Currency Returns Outpace DM Peers Year to Date
Source: Morningstar Direct as of 5/11/2023. EM Local Currency Sovereign represented by J.P. Morgan GBI-EM Global Core Index; US HY Corporates represented by ICE BofA US High Yield Index; US IG Corporates represented by ICE BofA US Corporate Index; Global Agg represented by ICE BofA Global Broad Market Index; US Agg represented by ICE BofA US Broad Market Index; EM USD Sovereign represented by J.P. Morgan EMBI Global Diversified Index.
Spreads among EM banks also do not appear to indicate stress, and the sector has returned 3.7% within the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index this year through April 30, 2023. Over the same period, banks within the ICE BofA US High Yield Index returned 1.6%. According to J.P. Morgan research, fundamentals among EM banks appear resilient, reflecting stable funding profiles and conservative balance sheet management. It helps that the EM banks who have issued in US dollars tend to be the larger, better capitalized ‘local favorites’ with diversified deposit bases, according to Bank of America’s research team. Although the bank sector weighting in EM corporate indices tends to be higher than in US indices, there is very little exposure to non-bank financial companies in EM, and these types of institutions tend to be much more sensitive to turns in the credit cycle.
J.P. Morgan also highlights the performance of additional tier one (“AT1”) bonds. AT1 bonds are issued by banks and are convertible into ordinary shares, or can be written down on either a permanent or temporary basis to fill holes in a bank’s balance sheet in a stressed situation, making them a good indicator of the market’s perception of banks’ ability to maintain capital adequacy. As shown below, EM banks have significantly outperformed their European counterparts (U.S. banks do not issue AT1 bonds).
EM Bank Bonds Have Outpaced European Bank Bonds
Source: J.P. Morgan as of 5/11/2023.
There are certainly potential risks if the mini-banking crisis continues or spreads. We believe the most likely impact to emerging markets would be from slower growth due to tightening of credit in the U.S. as regional lenders pull back, which is happening in the context of the Fed’s ongoing battle against inflation. In addition, general risk aversion and volatility has historically impacted “risk-on” asset classes such as emerging markets, even though this has not been the case this year.
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J.P. Morgan GBI-EMG Core Index: tracks bonds issued by emerging markets governments and denominated in the local currency of the issuer. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index. Countries are capped at 10% and floored between 1% to 3%.
J.P. Morgan GBI-EM Global Diversified Index: tracks emerging markets local government bonds that are accessible by most foreign investors. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index. Countries are capped at 10%.
J.P. Morgan EMBI Global Diversified Index: tracks USD-denominated emerging markets sovereign bonds. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index.
J.P. Morgan CEMBI Broad Diversified Index: tracks USD-denominated emerging markets corporate bonds. The weighting scheme provides additional diversification by more evenly distributing weights among the countries in the index.
ICE BofA US Corporate Investment Grade Index: tracks the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market.
ICE BofA US Treasury Index: tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market.
ICE BofA U.S. High Yield Index: tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. Original issue zero coupon bonds, 144a securities, both with and without registration rights, and pay-in-kind securities, including toggle notes, qualify for inclusion.
MSCI Emerging Markets Equity Index: represents the performance of emerging markets equities.
S&P 500 Index: consists of 500 widely held common stocks covering industrial, utility, financial, and transportation sector.
An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses, nor does the Index lend securities, and no revenues from securities lending were added to the performance shown.
All indices are unmanaged and include the reinvestment of all dividends, but do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment in the Fund. Certain indices may take into account withholding taxes. An index’s performance is not illustrative of the Fund’s performance. Indices are not securities in which investments can be made. The Fund’s benchmark index (50% GBI-EM/50% EMBI) is a blended index consisting of 50% J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified and 50% J.P. Morgan Emerging Markets Bond Index (EMBI). The J.P. Morgan GBI-EM Global Diversified tracks local currency bonds issued by Emerging Markets governments. The J.P. Morgan EMBI Global Diversified tracks returns for actively traded external debt instruments in emerging markets, and is also J.P. Morgan’s most liquid U.S dollar emerging markets debt benchmark.
Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The index may not be copied, used or distributed without J.P. Morgan’s written approval. Copyright 2023, J.P. Morgan Chase & Co. All rights reserved.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.
Emerging Market securities are subject to greater risks than U.S. domestic investments. These additional risks may include exchange rate fluctuations and exchange controls; less publicly available information; more volatile or less liquid securities markets; and the possibility of arbitrary action by foreign governments, or political, economic or social instability.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.
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