Are developed market bonds more risky than emerging market bonds?

Over the past few years there has been much discussion as to whether or not the bond bull market, which has been raging for more than three decades now, is finally over. Each January, disaster is forecast for the asset class – yields are ridiculously low, inflation is rising and interest rates, in the US at least, look to finally be on the way up. All very bad things for bonds.

But commentators have continued to be wrong and bonds have continued to survive. So are things finally about to change in the second half of 2017?

Increased risk in developed market bonds

When you look at certain statistics around developed market bonds, you could be forgiven for continuing to think the worst. TwentyFour Asset Management, who are fixed income specialists and manage the TwentyFour Dynamic Bond fund, ran some number last week that show that, since the 31 December 1999, the average interest rate risk of UK government bonds has risen by 72%*. That’s quite a scary statistic for an asset class that has historically been seen as the least risky after cash.

Ian Spreadbury, manager of Fidelity Strategic Bond fund, and a man of considerable experience in the asset class, is also downbeat on the outlook. Almost 10 years on from the early stages of the credit crunch and the global financial crisis, he thinks the background then is eerily similar to where we are today.

“2006 was a year of global interest rate rises, reasonably solid GDP growth and a modest pick-up in inflation. Both bond and equity market volatility were at, or close to, an all-time low. Stocks were strong and, not surprisingly, high yield was the best performing bond asset class with a return of around 10% – despite clear signs of deterioration in credit quality with concerns about share buybacks and event risk.”

So what’s different this time round?

Ian does believe there are some differences. “Firstly, global GDP is much lower at around 3% and, perhaps more importantly, nominal growth has continued to trend down to the lowest level since the 1930s – all despite unprecedented amounts of quantitative easing and a continuation of super low interest rates.

“Secondly, the structural factors that led to the credit crunch have intensified; in particular, high global debt to GDP, population ageing and wealth inequality. Thirdly, although both realised and implied volatility are very low, unlike 2006/7, global economic policy uncertainty is very high, implying an elevated risk of policy error.”

M&G head of retail fixed interest team, Jim Leaviss, is more optimistic. His team run the M&G Optimal Income, M&G Strategic Corporate Bond and M&G Corporate Bond funds that are all Elite Rated. He says that it isn’t the end of the bond bull market yet as the path to normalisation is unlikely to be in a straight line or very steep.

“There is still a lot of debt around in the West and Japan,” he said. “Countries, businesses and individuals all have a debt burden that would be vulnerable to quickly rising interest rates, so I don’t really see that central banks have any option but to take things slowly.”

Do emerging market bonds offer better opportunities?

Emerging market bonds have been out of favour for a number of years. As the US dollar strengthened, these countries’ national debt became harder to pay. But, many countries’ finances are now in much better shape. Reserves are rising and budgets are in surplus in many places. However, as with emerging market equities, emerging market bonds can experience high levels of volatility and are subject to a number of risks.

At the moment, key risks include low commodity prices, geopolitical risk, uncertainty around Trump policies, the impact of Brexit on Europe and a slowdown in China. Commodity prices seem to have stabilised for the time being though, Trump seems to be more open to compromise than previously thought, and the French election result (which rejected the anti-EU candidate) will have given confidence to emerging European countries such as Hungary and Poland.

Political developments can also have a notable influence on emerging markets – as we have seen recently with yet another possible impeachment in Brazil and in Venezuela after the Supreme Court ruling to strip parliament of its powers, which sparked global concerns the country was sliding towards a dictatorship.

But if US policy is less aggressive than expected, global growth is reasonably positive, commodity prices are slightly higher, the US dollar is less expensive and local currencies are more stable, emerging market debt should be more resilient.

*The average duration of gilts has gone from to 6.75 to 11.62, which translate to a 72% increase in interest rate risk (Source: Bloomberg).