EM can prove attractive for income investors

26 Oct, 2018 by Dwarka Lakhan

Once considered a niche asset class, emerging market (EM) bonds have become an attractive option for investors seeking higher yields to meet their income needs in the wake of relatively low yields offered by developed market (DM) bonds.

In fact, EM bonds are now “an asset class on its own” which “offer a good pick up over developed market yields,” says Matthew Strauss, vice-president and portfolio manager with CI Investments Inc. in Toronto. On average, EM yields are currently about 4% to 6% greater than DM yields.

EM Bonds, which behave in a similar manner to equities, have a low correlation to other asset classes, says Christine Tan, associate vice-president and portfolio manager with Sun Life Global Investments in Toronto, noting that “since 2008 correlation among developed market asset classes have increased significantly.” EM bonds therefore, represent a significant opportunity for portfolio diversification, and the reduction of volatility and risk, she adds.

Tan suggests that faster economic growth in EMs, accompanied by higher inflation, and consequently higher interest rates to contain inflation, have contributed to EM bonds offering much higher yields than DM bonds.

Incidentally, EM economies have been growing faster that DM economies for several years now. They are expected to grow by an average of 4.9% in 2018, compared to 2.5% for DM economies, based on April 2018 International Monetary Fund (IMF) forecasts. Strong growth has been accompanied by increasing demand for capital by EM governments as well corporations, leading to a substantial expansion of the EM bond market, which has now evolved into a fully integrated segment of the global bond market.

As a result, the size of the EM bond market has grown by an average of over 20% per year between 2004 and 2018 – faster than the growth rate of DM bonds – to reach over US$19 trillion or almost 13% of all bonds issued globally.

Currently, more than 65 different EM countries and almost 1600 corporations issue bonds, providing investors with geographic, credit quality, duration, and currency diversification.

But all EM bonds are not the same. They can be classified into two broad categories: sovereign debt and corporate debt. These two categories can be further subdivided into two additional categories: hard currency debt, and local currency debt.

Sovereign bonds are issued by governments of EMs in either hard currencies like the US$ and Euros or in the local currency of the issuing country. Corporate bonds are issued by domestic and multinational companies domiciled in EMs in either hard or local currencies.

According to Moody’s Investor Services, the “number of rated Emerging Markets sovereigns is growing, driven largely by Africa and Middle East countries.” Of the 101 sovereign bonds rated by the agency in Latin America, Emerging Europe, Africa and the Middle East and the Asia-Pacific as of September 1, 2018, 75 were rated with “stable outlook” – implying a relatively low level of risk.

“EM countries have come a long way over the last 20 years in terms of their macroeconomic stability and policy management,” says Morgan Stanley Investment Management in its 2018 Emerging Markets Debt Outlook. Though there remains room for reforms, sovereign balance sheets have improved across the board, reducing systemic risks, the report adds. These structural improvements in their macro conditions have improved their creditworthiness, lowering the risk of default, which is a primary concern among investors.

Strauss says that EM sovereigns offer lower yields than higher-yielding EM corporates; and that their default rate is lower, making them less risky. On the other hand. EM corporate bonds could face challenges “as we come to the end of the global cycle,” thereby increasing the risk of default.

Traditionally, the greater portion of EM debt has been s denominated in either US$, or Euros. However, this trend has changed in recent years with the greater portion of EM debt now issued in the local currency of the issuing country.

The shift to local currency bonds has resulted from improved credit ratings of emerging countries; lower debt levels; and higher levels foreign reserves – enabling EM countries to become less dependent on external currencies. Incidentally, bonds issued in local currency are not as susceptible to swings in major currencies, reducing currency risk for investors.

Yet, like their equity counterparts, EM bonds can be volatile. “A small change in sentiment can trigger volatility,” notes Strauss. Adds Tan, “EM countries are less mature and consequently have inherent risks” which can be magnified as a result of changes in market conditions

In its Q3 2018 Portfolio Insights, J.P. Morgan Asset Management surmises that although broad EM fundamentals at both the corporate and sovereign end remain strong, healthy US growth, higher US interest rates and a stronger US dollar have created a challenging environment for EM bonds. As a result, EM bonds, which were benefitting from record inflows at the beginning of the year are currently experiencing large outflows, resulting in negative performance, led by weakening currencies.

In addition, EM bonds have also been affected by downside pressures from currency weakness in countries such as Argentina, Russia, Brazil and Turkey. US-initiated trade tensions have also exacerbated volatility across the EMs.

In spite of current volatility, EM bonds will continue to offer higher yields but as Tan says, “there is less room to be wrong” when deciding where to invest.

A version of this article appeared in Investment Executive

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.