Global fixed income markets have experienced significant volatility after comments made by Federal Reserve Chairman Bernanke suggested that the US Central Bank’s bond purchases might be reduced. The market has interpreted Bernanke’s comments made in early May as a signal that the mantra of easy monetary conditions for an extended period has changed. US bond markets sold off sharply with 10yr bond yields trading 125 basis points (bps) higher in only 8 weeks. Th e Fed has since re - iterated that it does not plan to hike policy interest rates until the unemployment rate falls below 6.5% and as long as inflation remains contained.
Against a backdrop of rising US yields, Emerging Markets underperformed US bonds. Risk premiums for hard currency bonds rose; the EMBI Global diversified spread traded 40bps higher in July, compared with levels in May. Emerging Market (EM) currencies weake ned against the US dollar and bonds denominated in currencies of EM countries sold off; the magnitude of the local rate sell - off was comparable with the one experienced in hard currency bonds.
We believe that the sell - off has created an opportunity for l onger - term investors as the current spread pick - up at 330bps compensates investors amply for repayment risks associated with Emerging Market hard currency bonds. A high stockpile of foreign exchange reserves, which can shield against a sudden reduction of capital inflows, low budget deficits, which often translate into a benign issuance requirement, and low debt/GDP ratios and their associated manageable roll - over needs should create a favourable backdrop for hard currency assets. In addition, over the long er term, potential growth for Emerging Markets is higher than for developed countries, as young and productive populations enter the workforce, without the large contingent liabilities that hang over pension and health care systems in developed markets.
Our view that EM countries will perform well over the longer term, is particularly strong for countries, where a structural reform agenda underpins a sustained rise in potential growth. In addition, the interest income from EM hard currency bond markets (yields of around 6%) and the shelter from USD strength mark an interesting feature for EM hard currency bond investments in a volatile world for fixed income assets. This is particularly attractive for investors receiving very low cash rates on bank accounts.
A bond picker’s market
Country fundamentals mattered little in 2012. Yields were chased wherever available as global interest rate conditions provided a strong incentive to invest. Countries with large financing needs, either for the state budget or a big import bill, fared particularly well as investors were eager to add higher yielding bonds such countries offer. As conditions changed, this trend reversed, and countries with large funding gaps suffered disproportionately. From here, we believe that country differentiation and asset choice will be much more important as the market re - assesses financing conditions in a higher interest rate environment.
We prefer countries with strong structural reform agendas. Mexico, the Philippines and Colombia for example have embarked on a path towards improving the productive capacities of their economies. Tackling rigid labour and product markets or opening up certain sectors to competition has improved the investment climate.
Another investment theme we favour is focusing on countries with relatively low external vulnerabilities. By that we mean balanced trade accounts or sustainable inflows via direct investments or overseas work ers’ remittances. Many Eastern European countries fall into this category, as they had to adapt their growth models away from debt - fuelled domestic demand. Their new approach often entails export - led models, which have been helped by strong improvements in competitive advantages, often without currency devaluations. The Baltic countries for example which were all suffering from severe recessions as competitiveness was re - established, now act as role models for Southern European adjustments in prices and wag es. Latvia was the best performing economy in the EU in real GDP growth terms in 2012. Local currency investments, particularly if the US dollar is used as the funding currency, warrant caution as higher US yields underpin the greenback.
Local currency d enominated bonds could suffer losses as Central Banks shift their stance from rate cuts to rate hikes in order to prevent importing inflation from weaker exchange rates. In addition, volatile global markets are not conducive for carry trades in general, wh ich often puts local currency yield curves on the back foot.
Outlook for Emerging Market bonds
We think that bond markets globally will continue to experience volatile trading conditions, until the path for developed market interest rates, most importa ntly US Treasuries, becomes clearer. Differentiation among emerging debt markets will remain an investment theme in our opinion amid tougher financing conditions. Primary markets as a result could become quieter, but we think that new bond placements will continue to offer opportunities as issuers offer extra yield compensation for access to the market.
In the longer term, we think that the EM debt market is attractive from a global fixed income perspective, as younger populations entering workforces acros s many Emerging Markets will likely lead to better growth trajectories. Fiscal strength, evidenced by low budget deficits and debt/GDP ratios, creates low net financing needs for sovereigns in hard currency. Historical vulnerabilities stemming from the balance of payments are less of a concern amid a stockpile of foreign exchange reserves.
Philip Fielding, CFA Portoflio Manager Emerging Markets Debt
