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Positive externalities?

  • 06Sep 18
  • Roubesh Adaya Senior Investment Specialist, Aberdeen Standard Investments

Why have external factors presented investors with a strong opportunity over the last two years to allocate to emerging-market debt?

Positive externalities?

Why have external factors presented investors with a strong opportunity over the last two years to allocate to emerging-market debt?

The yield to maturity of emerging-market (EM) U.S. dollar-denominated bonds has reached the same level as in February 2016 when oil was trading below $30, in spite of improving fundamentals and an accelerating pace of economic growth in developing economies.

Many of the factors that can be attributed to this sell-off are not inherent to emerging markets. As much as 60% of the negative returns year to date can be associated with rising U.S. Treasury yields.

Chart 1. The yield levels of emerging market USD bonds were at the same level as in February 2016

Source: Aberdeen Standard Investments, Bloomberg, JP Morgan EM $ Sov = EMBI Global Diversified, EM $ Corporate = JP Morgan CEMBI Broad Diversified, EM LC Sov = GBI EM Global Diversified, May 15, 2018. Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

We consider some of the factors driving emerging-market bond prices below, and why we believe the current sell-off presents not only an attractive entry point, but an opportunity to actively (albeit selectively) add risk to one's portfolio.

Performance drivers across EM bonds

Let’s first take a look at USD sovereign bonds. Year-to-date, spreads in USD sovereign bonds have widened by 0.37% to 3.22%. The yield of the JP Morgan EMBI Global Diversified has increased by 0.92%, to 6.20%, over the same time period. In terms of returns, EM dollar sovereign bonds have returned -3.9% year-to-date, with -2.7% attributed to rising U.S. Treasury yields.

Since the high of the EM sovereign spreads in February 2016, EM dollar sovereign bonds have delivered +17.8% (in USD, unhedged), in spite of Treasury returns detracting -4.6% from the overall performance. This demonstrates the ability of the asset class to deliver positive returns in spite of the rising interest rate environment. Frontier bonds in particular have benefitted from this situation, with their lower duration profile insulating such bonds to a certain extent from the Treasury impact while their larger spreads offer further room for compression.

Chart 2. Higher U.S. Treasury yields have been the primary driver of the bond sell-off

Source: Aberdeen Standard Investments, JP Morgan EM $ Sov = EMBI Global Diversified, Bloomberg, May 15,2018. Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Now let’s look at USD corporate bonds. Similarly in emerging-market corporate bonds, U.S. Treasury yields have been the dominant drivers of returns year to date, with Treasury returns accounting for -1.74% of the -2.41% returns the JP Morgan CEMBI Broad Diversified has experienced year to date. Spreads have widened, particularly across lower-rated bonds; BBB rated bonds widened by 11 basis points (bps) year to date, while BB-rated bonds widened by 23 bps and B rated bonds widened by 43 bps on the S&P.

During the recent bond sell-off, emerging-market corporate bonds displayed higher resilience than other fixed-income dollar-denominated asset classes. This is due in part to their higher credit quality as an investment-grade asset class (BBB-) but also because they tend to be composed of less leveraged companies than in developed markets. The JP Morgan CEMBI Broad Diversified, which represents the broader EM corporate bond market, offers an attractive yield of 5.9% with a relatively short duration of 4.7 years.

While improving economic growth and falling inflation in emerging markets offer a “Goldilocks” environment for corporates, an index comprising over 630 issuers and 1391 bonds requires careful selection affordable to few investors.

Let’s move to local currency bonds. A rising U.S. dollar has meant that investors investing in emerging-market local currency debt suffered from a currency return perspective year to date. However, in spite of the negative currency returns that have particularly affected investors with a USD base currency, local currency bonds have outperformed hard currency debt so far this year.

In USD (unhedged), the JP Morgan GBI EM Global Diversified has returned -1.09% year-to-date, but this comes in the context of strong performance - local currency bonds had returned +13.08% over the last two years (in USD, unhedged).

Selection has been key in emerging-market local currency bonds, where in spite of overall index negative returns, several countries delivered positive returns.

However, the overall index, which consists of 18 countries, dipped into negative performance territory this year due to Argentina and Turkey, which posted disproportionately negative returns relative to the rest of the index. Argentina’s is currently in discussion with the International Monetary Fund (IMF) for financial support. Turkey continues to suffer from a high and poorly financed current account deficit.

Chart 3. Argentina and Turkey have been the main drivers of local currency bonds underperformance

Source: Aberdeen Standard Investments, YTD returns of JPM GBI EM Global Diversified in USD unhedged (%), May 15, 2018. Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

While the currency impact has detracted from performance in USD terms, the interest-rate component continues to contribute strongly to returns. Investors in emerging-market local currency bonds have been able to take advantage of the accommodative monetary policies in emerging markets.

Unlike in the U.S. where the U.S. Federal Reserve (Fed) is tightening monetary policy, easing inflation has afforded central banks in emerging markets additional leeway to cut interest rates.

Selectively adding EMD exposure

Given the predicted negative government bond returns in many developed markets over the next few years, as many advanced economies engage in the tightening of monetary policy, we believe return-seeking investors in fixed income should gradually increase their allocation to EM bonds.

Positive technical factors such as the proposed inclusion of Chinese local currency debt in the global aggregate indices beginning in June 2019 should account for as much as $250 billion according to UBS, raising Chinese debt exposure in the index from a mere 0.6% to 5.5%. This is also likely to raise foreign ownership of Chinese local currency debt from approximately 3.5% to 8% or 9% over time (in contrast to 37% foreign ownership of U.S. Treasuries).

Given the rally the asset class has experienced since 2016, the recent bout of underperformance has offered an attractive point of entry for investors willing to stomach short-term volatility.

The underperformance of the asset class has been driven by factors unconnected to EM fundamentals, which remain strong and improving on average – accelerating real economic growth in EM is expected to rise to 5.0% by 2022, while the decelerating growth in advance economies is expected to drop to 1.5% by 2022, according to the IMF’s Spring 2018 forecast.

The asset class has also matured into a wide range of sub-asset classes, ranging from sovereign bonds in USD to corporate bonds in local currencies.

Investors have increasingly tailored their allocation to EM debt, assessing the sub-asset classes’ unique characteristics and their willingness to be exposed to either interest-rate or currency risk.

Chart 4. Emerging-market debt offers a wide range of risk-return profiles to match investors’ needs

Source: Aberdeen Standard Investments, Bloomberg, April 2015 to April 2018 (Monthly data over last 3 years). EM LC Sovereign Bonds (Hedged, EUR), EM LC Sovereign Bonds (Hedged, GBP), EM LC Sovereign Bonds (Hedged, USD), EM $ Corporate Bonds (Hedged, EUR), EM $ Corporate Bonds (USD), EM $ Corporate Bonds (Hedged, GBP), EM $ Sovereign Bonds (USD), EM $ Sovereign Bonds (Hedged, EUR), EM $ Sovereign Bonds (Hedged, GBP), EM $ Corporate Bonds (Unhedged, EUR), EM $ Sovereign Bonds (Unhedged, EUR), EM LC Sovereign Bonds (Unhedged, EUR), EM $ Corporate Bonds (Unhedged, GBP), EM LC Sovereign Bonds (Unhedged, USD), EM $ Sovereign Bonds (Unhedged, GBP), EM LC Sovereign Bonds (Unhedged, GBP). Past performance is not an indication of future results. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Opportunities for active management

The recent sell-off in EM debt has refocused investors’ attention on idiosyncratic risk, highlighting the need for active portfolio management. This has been particularly important after two years of rapid inflows, increasingly through passive allocations, which has often resulted in the indiscriminate buying of bonds. “EM tourists” and exchange-traded funds (ETFs) often tend to target certain specific securities in order to replicate beta exposure (a similar return profile as an index comprising many more securities) and/or due to the liquidity profile of certain instruments.

We believe that this offers opportunities for active management. The ability to make informed decisions based on deep fundamental research allows active managers to use the recent externalities impacting emerging markets to take advantage of market opportunities.

Important Information

Past performance is not an indication of future results.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.

ID: US-070818-69882-1