Four reasons to be optimistic about emerging market bonds

Emerging market bonds have had a pretty mixed year so far. Those that are issued in ‘hard currency’ (the US dollar) have done best but are still only just in positive territory year to date, while local currency bonds have struggled and are down some 5%*. But, as the health of the global economy continues to improve could we now be at a turning point for the asset class?

Claudia Calich, manager of M&G Emerging Markets Bond fund, says there are four reasons to be optimistic.

“We do not wish to downplay risks from the slow vaccination rollout in emerging markets so far (compared with most developed markets), but we do see several reasons for optimism for the asset class going forward,” she said.

“Firstly, economic growth in emerging markets has rebounded and remains very robust. The latest International Monetary Fund (IMF) projections are forecasting 6.3% growth this year and 5.2% in 2022 for emerging market economies.

“Interestingly, the IMF also anticipates a slightly more balanced growth outlook; growth projections for Asia have been downgraded slightly – largely as a result of knock-on effects from India’s recent severe COVID-19 experience – and increased in other regions, especially in Latin America.

“Secondly, emerging market currencies are down by more than 3% on a year-to-date basis and seem undervalued to us. After the global financial crisis of 2007-2009, strong and persistent inflows into emerging market debt caused many emerging market currencies to appreciate in value and the US dollar to fall to historic lows. This time around, however, flows into emerging market local currencies have been more muted and, while the US dollar has depreciated from its pandemic highs, it remains significantly more expensive than it was during the period from 2011 to 2014. In our view, emerging market currencies could present investors with investment opportunities over the medium term.”

Jason Borbora-Sheen, co-manager of Ninety One Cautious Managed funds, tells us more about the opportunities in local currency emerging market bonds in this podcast:

“Another reason for optimism is that many emerging market central banks have pre-emptively raised interest rates ahead of the Federal Reserve (the US central bank),” continued Claudia. “Among the 15 largest emerging market central banks, six have already hiked rates at least once this year. June alone saw the largest number of rate hikes since 2011 (Brazil, the Czech Republic, Hungary, Mexico, and Russia all increased interest rates), helping to reduce risk from inflation. Many emerging nations still have a lot of spare capacity in their economies and should have the flexibility to close output gaps, even well into 2022.

“The final reason for optimism is that, despite the shock to the global economy in the past 18 months, emerging market companies currently offer relatively healthy credit metrics, in our view. Recent analysis has shown that net leverage among emerging market companies is still significantly lower than that of developed market companies. Furthermore, among higher-yielding emerging market corporates, the coverage ratio (a measure of how easily a company can use its cash flow to pay interest on its outstanding debt) is now higher than that of their high yield peers in the US for the first time since 2013. Against this backdrop, we expect relatively low default rates (approximately 2% to 3%) in the high yield segment of the emerging market corporate bond market in 2021.”

Other managers investing in emerging market bonds

Of course, another attraction of emerging market bonds is the higher yields they tend to offer. And other Elite Rated managers are investing selectively in this area for that very reason. One such manager is Richard Hodges, who runs Nomura Global Dynamic Bond.

“One area where we find attractive yields is in selected emerging markets,” he said, “and our overall allocation is close to 15%. Here we are prepared to take some risk as we believe we are compensated for it.

“In Russian and South African sovereign local currency bonds we find yields to maturity in excess of 7% and 10% respectively. Most of their risk derives from the currency exposures and here we employ option-based hedging to mitigate volatility at a fraction of the cost of more simplistic forwards-based hedging. We also own hard currency Egypt sovereign debt and here again we earn yields to maturity in excess of 9%”. Another example is Jim Leaviss, manager of M&G Global Bond fund. “We still see attractive medium-term value in select emerging market bond markets, with the asset class continuing to offer elevated real yields and attractive fundamentals,” he said. “With a number of local currencies coming under pressure as a result of a rise in the Delta variant of COVID-19 we took the opportunity to establish some local currency Asian positions during the month.”

Murray International Trust also has a preference for emerging market bonds in its fixed income allocation. A total of 9% of the portfolio is allocated to Asia and emerging market bonds with the likes of south African, Indonesian, and Mexican debt amongst its top ten bond holdings**.

Jupiter Strategic Bond has an even larger allocation of 27% invested in Asia and emerging markets although no individual bond from these areas makes it into the current top ten**.

*Source: FE fundinfo, total returns in sterling, 1 January to 15 September 2021
**Source: fund factsheet, 31 July 2021