Value in government bonds ahead of the Fed

Jan Dehn, head of Research at Ashmore, takes a closer look at valuations in global bond markets ahead of next week’s likely first hike by the Fed.

He provides a review of the stocks of government in debt in Emerging Markets (EM) and developed economies and the current level of yields, which, in EM, is now the same as in 2006 when the Fed had rates at 5.375%.

The note also includes a discussion of Bank of International Settlements (BIS’s) claim – based on a newly published paper – that sovereign ratings are not biased against EM issuers. Finally, Jan covers the Venezuelan election and the impeachment in Brazil.

Sharp contrast in the yields on EM and DM government bonds
The Fed is preparing to hike interest rates for the first time in many years. This marks the beginning of the end of a rally in fixed income that originated in the early 1980s when 10 year US treasury yields were 16%.

How the end of the benign environment for bonds unfolds depends crucially on how well or badly borrowers behaved during the good times. In the US, total debt levels (public and private) more than doubled over the period from 163% of GDP in 1980 to 337% of GDP as of the end of 2014.

US government debt to GDP has doubled from 51% in 2000 to 100% in 2014.
A similar pattern exists in other heavily indebted developed countries.

Eurozone government debt to GDP went up by a whopping 44% from 65% of GDP to 94% of GDP between 2007 and 2015, according to the IMF. Rising debt to GDP is not necessarily a problem per se; what matters is how the debt is priced. A very high yield can still make debt attractive even if the issuer is heavily indebted.

The big problem in developed economies right now is that debt levels are very high at a time when bond yields are very low. This suggests that investors are simply not being paid for the risk.

The situation in EM is starkly different. At the end of 2014, the average government debt to GDP ratio in EM had fallen to just 41% from 55% as recently as 2002. More importantly, the compensation investors are being paid for taking exposure has not declined.

Index weighted average EM bond yields are today just 1bp lower than at the end of 2006. Local bond yields and yields on sub-IG corporate and sovereign debt are actually higher today than in 2006 when the Fed Funds rate was 5.375%.

Only EM IG sovereign and corporate bonds trade at marginally lower yields today than before the crisis. For comparison, the chart also shows how US treasury yields have fallen over the period. German and Japanese bond yields have fallen even more.

What should investors make today of this sharp contrast in the yields on EM and DM government bonds? One perspective is that markets are pricing risks correctly and that EM bonds simply have to offer higher yields because they are that much more risky.