Emerging Market Debt Opens Year Outperforming Expectations by Kusum Sull

Emerging Market (EM) governments have raised a total of $19 billion through bond sales since the beginning of the year, exceeding market expectations given Q4 of 2018’s sharp EM selloff. During the second week of 2019 Saudi Arabia issued bonds with a total value of $7.5 billion, as well as Columbia selling more of their dollar bond due 2029. Additional deals include issuances from the Philippines, Uruguay and Mexico. This level of activity brings to the light the case for investing in the EM bond market.

 

The positive sentiment EM debt markets opened to support a 3.1 percent rally of the iShares JPMorgan USD Emerging Market Bond ETF (exchange traded fund).

 

The increase in EM bond funds weekly flows between December 15th and January 16th suggests that last year’s EM selloff has factored in the correction, implying that the value of EM assets currently is more accurate, providing an ideal opportunity for investors to buy. Consequently, this provides a strong argument for investors to consider asset allocations within their portfolios with a greater weight on EM bonds.

 

EM debt securities’ attractive returns; market volatility; economic governance amongst developing economies; and movements in currencies are arguably the most significant factors for investors, when considering the impact of EM debt on overall portfolio returns.

 

The demand for EM debt securities is generally explained by the exceptionally low yields from developed market bonds (currently well below three percent), making the average six percent available on EM bonds a significantly more attractive investment. Additionally, developing market yields have not risen above pre-financial crisis levels given persistently low interest rate and the impact of quantitative easing in Europe. Thus, EM yields are clearly more attractive to investors than developed market yields, where interest rates are generally high across the developing economies, with the expectation that rates should continue on this level.

Carry traders’ current strategies are indicative of the potential in EM debt emphasised by the opportunity to achieve returns just below nine percent due to the seven-month low in currency volatility, reported by Bloomberg. The Fed’s outlook for less aggressive rate hikes combined with speculation of a U.S.-China trade deal means that carry traders are continuing with high yielding EM debt securities to increase returns. However, despite low EM volatility, this strategy will not necessarily hold when factoring movement in currency.

 

Over the long term, returns on EM debt are partly subject to currency volatility. Dollar rate hikes for instance can determine currency volatility in both the short and long term. It is important to note that currency volatility will have the greatest impact in the long term depending on whether currencies are priced correctly. Aberdeen Standard Investments have predicted an appreciation in EM currencies based on predictions that EM currencies are currently valued below their actual values. Therefore, assuming such an appreciation against the US dollar, EM bonds denominated in dollars will negatively impact investors’ total returns. As a result, investors are likely to closely monitor currency volatility, as the current factors determining the outlook on the EM bond market cannot consistently ensure high returns for dollar denominated bonds.

 

Nonetheless, EM debt is significantly more attractive than ever before due to fundamental changes in economic governance – partly in response to the experiences of the 1998 Asian Crisis. EM economies are mitigating the risks of situations as such by ensuring debt is being issued in more local currencies than the US dollar. Moreover, central banks now hold larger reserves in US dollars. Finally, the development of fiscal and monetary policy in EM economies signals to investors greater certainty and economic stability, which will continue to increase the attractiveness of EM debt securities.

 

Overall, the EM debt market exceeding expectations in the space of three weeks is indicative of the short-term impact from last year’s EM selloff, but also highlights the fundamentals that make EM bonds compelling in asset allocation strategies for the long term. Nonetheless, global political instability and slow growth forecasts – reinforced by the IMF cutting expectations for world economic expansion to the lowest level in three years – are all factors that must be carefully considered going into a bear market.

 

1 Comment

  1. Dwana Woelfel on March 15, 2019 at 2:45 pm

    I don’t commonly comment but I gotta say thanks for the post on this amazing one : D.

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