The popularity of emerging markets as an asset class is rising for the first time since the “taper tantrum” of May 2013. Recent weeks have seen record inflows for emerging market bonds, particularly those denominated in hard currencies, with inflows of $3.2bn in the first week of July alone.
There are several compelling reasons why bond investors are returning to the emerging markets sector and why short-duration bonds in particular represent an attractive proposition. Let us examine each of them in turn.
Fundamentals: robust growth, greater stability
The “growth gap” between emerging and developed markets is widening in the former’s favour. We expect emerging markets to grow by a robust 4.5% this year. One reason for this is that economies such as Russia and Brazil are now coming out of recession; in tandem, economies such as India and China are enjoying improved
The recovery in commodity prices is also key to emerging markets’ renewed appeal. The apparent bottoming-out is good news for developing nations, which tend to be producers of raw materials. Growing signs of stability in this regard make it easier to promote projects and investments.
Stability and low commodity prices lead to little inflationary pressure, which can encourage Central Banks to reduce interest rates. Such a move is expected in the likes of Brazil, India, Indonesia, Russia and Turkey and is in keeping with the loose monetary policies at present favoured by the European Central Bank, the Bank of Japan and the US Federal Reserve.
It is interesting to note that numerous macroeconomic developments that originally shocked the financial markets have failed to play out as dramatically as initially expected. The Federal Reserve’s policy of a rapid rise in interest rates, the decline in China’s growth and the instability of commodity prices have all proved less significant than first feared. This further explains investors’ restored faith in emerging markets’ fundamentals.
Technicals: strong dynamics
Although investor demand is rising, the net supply of bonds in the emerging market sector is declining. This has been the case since the beginning of the year, as a result of which the quantity of new issuances actually no longer covers the quantity of maturities, coupons and premature terminations. This represents an extraordinary situation.
What this means is that the vast majority of the investment environment is shrinking. Asia, in light of the weakening renminbi and favourable refinancing conditions in domestic markets, provides the sole exception – but
even then only with regard to investment-grade rather than high-yield bonds.
The combination of an abrupt rise in demand and a contracting investment environment leads to inflows, which in turn lend themselves to strong technical market dynamics. Together with the attractive fundamentals discussed above, these significantly bolster the appeal of the asset class.
Ratings: reflecting risk and reward The level of negative-yielding global debt is rising. At present it stands at around $11.7trn, with developed market bonds accounting for the overwhelming majority of this figure.
As a result, provided market conditions remain stable, emerging market bonds offer a more interesting risk-reward proposition than their counterparts in fully industrialised countries. This is particularly so in the case of higher-coupon bonds. Investors who favour emerging market bonds over developed market bonds might expect to receive 80-100 basis points more in yield for investment-grade bonds and around 200 basis points more for high-yield bonds. This is reflected in attractive ratings.
Another edge: risk premium versus debt level
Political risks currently represent arguably the greatest threat to bond markets in emerging economies. Crucially, however, the same can be said for many developed economies.
This being the case, we would argue that this is another reason why emerging market bonds represent a more appealing investment proposition than their counterparts in the US and Europe, as the ratio of risk premium to debt level appears more attractive.
Limiting risk: the growing appeal of short duration bonds Short-duration bonds are likely to offer an especially sound risk-reward profile for investors who wish to limit risk and volatility. This is as true for emerging markets as it is for anywhere. In tandem, with interest-rate curves flattening over the course of the past year, the traditional appeal of longer duration bonds is now much less obvious.
In conclusion, the case for investing in emerging market bonds seems stronger now than it has been for at least three years. It is supported by both fundamental and technical analysis and by an attractive risk-reward profile. Following a period in which global investors have been underweight in this asset class, we therefore see real benefit in re-entering the sector at an opportune juncture and with a tailwind driven by ever-growing demand.
Warren Hyland is portfolio manager on the Muzinich Emerging Markets Short Duration fund