Emerging market debt benefits from the search for yield

The long-shunned emerging markets are back in favor among investors, as documented by record-high inflows into emerging market bonds. From an investor’s point of view, this raises the question of whether that is a new long-term trend or just a flash in the pan.

Chasing changing investment trends is traditionally a part of the business of financial markets. Watching these shifting trends, even for old stagers among the market participants, is always interesting – especially since the question automatically comes up as to the reasons for that trend and whether it makes sense to participate.

Currently, such thoughts turn toward the emerging markets, since investors have recently started to pour money into that segment. That brings back into favor a part of the financial markets that many investors mostly tried to avoid in the past few years. The change of heart is reflected in the performance of leading emerging market bond indices. So far this year, they have locked in double-digit percentage point gains, both in hard currency and in local currency. The strength of this development is also demonstrated by a recent seven weeks of record-high inflows into emerging market debt.emergening-market-debt-to-gdp-read-only

Yield advantage lures

There are several reasons for the huge inflows. The main argument is clearly the pressure to search for yield in a low-yield environment. In a time when many bonds from highly rated issuers carry a negative yield, the average yield premium of emerging market bonds of around 400 basis points looks highly attractive to many investors. The current prevailing mindset in that regard is summarized by Gordian Kemen, global head of EM Fixed Income Strategy at Morgan Stanley: “The global hunt for yield, supported by dovish G3 central banks and extremely low core market yields, is incentivizing investors to seek higher-yielding assets, including emerging market fixed income.”

In addition to that, market experts also point to other positive changes in the environment. The world’s largest asset manager, Blackrock, for example, speaks about reversing cyclical challenges that led to poor emerging markets returns in recent years. According to them, weaker currencies with a lag have led to improving trade balances. Further plus points for them are stabilization in the oil price and China’s slowing economy. Also mentioned are ousted market-unfriendly governments in key economies such as Brazil. Besides this, Blackrock forecasts room for further upside for the resumed portfolio flows into emerging markets because most investors would still be underweight in the asset class.

“The Great Migration to Emerging Markets debt has kicked off. People are flocking to the asset class when yields are zero or less elsewhere,” says Sergio Trigo Paz, head of BlackRock Emerging Markets Fixed Income.

Not to be underestimated as a support for the economy are monetary conditions in emerging markets, which are currently the most expansionary since the last three years. A monetary policy stance indicator calculated by Dutch asset manager NN Investment Partners has risen sharply recently. According to Senior Emerging Markets Strategist Maarten-Jan Bakkum, central banks in emerging countries will continue to loosen their monetary policy, as long as the global liquidity environment remains benign and inflation in the emerging world continues to decline. Another important point is that emerging market growth has accelerated for the first time in four years, while developed market growth has decelerated. This leaves the emerging market and the developed market growth differential to pick up this year and into 2017. Despite the turmoil in Turkey, the sentiment around emerging markets was also helped recently by political considerations: among them, a staggering EU, whose fragile status is documented by the British Brexit vote, a U.S. presidential campaign which looks more like a reality TV show than a serious political contest, or a Japan, whose fiscal and monetary policy is reckless.

Don’t forget the risks

Despite the current friendly mood around emerging markets, investors should not close their eyes to the risks. One of the biggest is addressed by the Financial Stability Board of the Bank for International Settlements. In a recent note directed at the G-20-leaders of the 20 most important industrialized and emerging countries, the bank rang the alarm bells. According to internal statistics, the debt of non-financial corporations in the major emerging markets increased on aggregate from less than 60 percent of GDP in 2006 to 110 percent at the end of 2015. That is well above the corresponding ratio in advanced economies, and the high level of corporate debt has contributed to overheating in some of these economies, thus increasing the risk of financial distress in the coming years. Also critical in that context: In the years 2016 to 2018, bond repayments of $340 billion are due. That’s 40 percent more than in the previous three years.

How difficult it will be to serve the debt depends on the U.S. dollar, which is often used as a financing currency. That brings the U.S. federal reserve into play, since its monetary policy influences the value? of the dollar. The dependence on such an external factor leaves the emerging markets in an uncomfortable situation, especially since the correlation between the worldwide bond markets and that in the US is still very high. But at least the emerging markets have managed it to reduce their vulnerability by introducing more flexible exchange-rate regimes. Unfortunately, that step would probably not help to avoid new stress in the system if the tendency toward more protectionism in the world should prevail, since exports make up 23 percent of the GDP generated by emerging markets.

Conclusion

After weighing pros and cons, it is clear that investments in emerging market assets like bonds still carry significant risks. But that is no reason for investors to shun them completely. That view is backed by the fact that there are hardly any risk-free investments left in the world, and that the risks are compensated by a yield premium considered to be less risky compared to other assets. Also, emerging markets bonds can contribute to the diversification of a portfolio. But that does not mean that one should become too greedy, only because an asset class carries a comparable high yield. Investors should instead lean back and remember that in order to earn higher returns, you have to take greater risk. Although this is a very basic rule, it pays off to follow it, and it will probably also help now to put the recent rush into emerging markets into perspective.

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