Time to Revisit Emerging Market Bonds?

Emerging markets (EMs) have had a tough time over the past few years. The prospect of interest rate hikes in the U.S. prompted many investors to pull their money out of developing world assets—particularly local currencies—and channel their money instead into hard currency assets. China’s continued slowdown has also negatively affected many emerging markets.

But now the time may be right to look at the asset class again. Developed market bond yields remain near record-low levels, with some £10 trillion worth currently trading at negative yields. While EM bond yields have also declined in recent months, they remain solidly in positive territory, offering a clear yield premium over developed market bonds.

Fears that the U.S. might embark on an aggressive hiking cycle have eased. Even if the Federal Reserve raises rates again soon, it remains likely that the overall pace of hikes over the next few years will be slow, providing a more stable background for emerging markets. The recent stabilization of commodity prices has also been beneficial. A number of major economies are heading back to growth, and fears of a sudden slowdown in China have faded. For those willing to consider allocating to developing world bonds again, there are a growing number of opportunities developing in both bonds and currencies.

For example, some analysts expect South Africa’s bonds to lose their investment-grade status. In June, the country narrowly avoided having its debt downgraded by Standard & Poor’s from its current BBB- rating to junk status, but the ratings agency has maintained its negative outlook amid concerns about the consequences of low economic growth. However, we expect the South African government to do everything it can to maintain its investment-grade status. At the same time, the stabilization of commodity prices has helped the economy, the inflation picture is benign, and real interest rates are relatively high. So we believe the possibility of the debt being downgraded has been over-estimated by the markets, and the debt is therefore underpriced and offers good value.

The Mexican peso is similarly undervalued, in our view. There are various reasons for the currency's weakness, including the fact that it is the most liquid emerging currency (making it an ideal proxy for the asset class) and the negative impact of some of the recent comments about the country from U.S. presidential candidate Donald Trump. However, a combination of stable politics, market-friendly macro policies and progress on structural reforms mean that the fundamentals in Mexico are stronger than the currency value suggests. We therefore think that the peso offers a good buying opportunity at these levels.

The ability to hedge risk through short positions is also crucial. For example, there has recently been a strong case for being short the Turkish lira recently as President Recep Tayyip Erdogan’s regime has become increasingly autocratic and the country has faced economic slowdown, a widening budget deficit and sovereign downgrades from both S&P and Moody’s.

The emergence of new opportunities does not mean that the risks associated with emerging market bonds have gone away. The asset class remains heterogeneous, encompassing countries that display markedly different characterisics and challenges, and are at different stages of their economic cycles. Identifying the best opportunities—and the biggest risks—requires in-depth research and analysis. We believe that, on a selective basis, many emerging market bonds and currencies offer attractive opportunities for investors seeking yield, provided that the appropriate hedges are in place and there is sufficient emphasis on downside protection. Given that developed-world yields look set to remain low or negative for some time to come, we believe there is currently a strong case for increasing exposure to emerging market bonds.

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