Consider HY Emerging Markets Bonds Amid Reflation

In an ever-changing interest rate environment, keeping tabs on the numerous corners of the yield market can be difficult. To help investors stay informed, we offer monthly commentary on income investing, covering the latest news, trends and investment opportunities.

Higher rates and inflation are a major challenge for any fixed income asset class. However, we believe that high yield corporate bonds—particularly emerging markets debt—may have the potential to better withstand these pressures in the current environment, when higher growth is the driver and volatility remains subdued.

The new year started off with a sharp increase in U.S. government bond yields following the Georgia Senate runoff elections, and rates continued to climb through the month. The 10-year rate topped 1% and ended January safely above that. This level was last reached prior to the March 2020 selloff, reflecting a consensus view of increased economic growth driven by the vaccine rollout and significant fiscal stimulus. The increase in long-term rates is notable given the Federal Reserve’s (Fed’s) indications that there will be no tapering for the foreseeable future, and given the equity market volatility experienced late in the month.

Reflation has, again, become a dominant theme driving fixed income markets, and the bond market has been flashing signals on expected growth and inflation. The yield curve is at its steepest level since mid-2017, when measuring the difference between the 10-year and 2-year yield.¹ In terms of inflation, breakeven inflation (the difference between the 10-year nominal rate and 10-year TIPS, which measures the market’s expectation for inflation) reached its highest point in two years, now firmly above 2%.²

We believe income investors should maintain exposure to high yield bonds in this environment. With the Fed on hold, interest rate volatility may remain at low levels. A sharp, unexpected rise in rates is certainly a risk investors must be aware of. Higher yields, however, can provide a cushion against rising rates, and higher growth is positive for spreads. Over the past decade, the correlation of U.S. and emerging markets high yield corporate bonds to inflation, although not strongly positive, is only slightly below that of U.S. equities and higher than investment grade bonds and U.S. Treasuries (which has a negative correlation). Interestingly, their correlation to inflation is also higher than U.S. REITs and similar to natural resources equities.³ The asset class yields approximately 5.6%, which is well above the Fed’s stated inflation target of 2%, potentially allowing income investors to out-earn inflation and maintain purchasing power.

Emerging markets high yield corporate bonds denominated in U.S. dollars may be particularly attractive, and provide a way for income investors to benefit from higher global growth, which is expected to reach 5.5% this year according to the International Monetary Fund, reflecting an upward revision from their October estimate. China’s remarkable economic recovery over the past year plays a big role in that, and Chinese issuers have significant representation in the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index, as do economically sensitive sectors like real estate, banking, basic industry and energy, which may perform well in a higher growth environment. High yield emerging markets bonds can diversify a U.S. high yield exposure given this differentiated issuer, country and sector exposure.

In addition to diversification, emerging markets high yield corporate bonds also provide a compelling relative value opportunity within a global high yield portfolio. The asset class currently provides a yield that is 1.23% higher than U.S. high yield bonds (as of January 31, 2021), driven by a pickup in credit spreads that is above the 5-year average.⁴ Average effective duration is lower (3.55 versus 3.80), potentially providing additional cushion if rates continue to rise. Emerging markets high yield bonds also compare favorably to U.S. high yield bonds in terms of quality, particularly in light of the significantly higher spread levels, with higher exposure to BB rated bonds and lower exposure to CCC and below. Emerging markets high yield corporates have generally exhibited impressive discipline over the past few years, and have lower leverage and higher interest coverage ratios compared to U.S. high yield. Default rates have historically been lower than U.S. high yield, and that was also true in 2020.⁵ As a result, we believe investors are getting attractively compensated relative to the risk they are taking.

The VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM) provides exposure to U.S. dollar denominated emerging markets high yield corporate bonds. The strategy incorporates country and issuer caps to increase diversification and avoid overconcentration. The Fund’s 30-day SEC yield was 4.81%, as of January 31, 2021. See standardized performance here.