Yield Opportunities Abound in Emerging Markets Bonds
TOM BUTCHER: Fran, what do you see as the current opportunities in emerging markets debt?
FRAN RODILOSSO: I think investors have a variety of opportunities to look at within the emerging markets debt space. It represents a diversified set of asset classes, and for investors today I would consider 1) local currency sovereign debt, 2) hard currency sovereign debt, and 3) hard currency corporate debt.
With EM local debt, the opportunities are best summarized by yields on average of 6%1 or greater, but the scope of this opportunity depends on your view on global growth, commodity prices, on rates and credit markets in general. By investing in local EM markets, you will get exposure to EM currencies, and this generally reflects a positive view on global growth, and commodities prices, but perhaps not such a positive a view on the U.S. dollar. This is one way to play the opportunities and to get extra yield, given this environment where we have $12 trillion in negative-yielding debt and virtually no yield opportunities in developed markets sovereign debt.
On the EM hard currency sovereign debt side within the investment-grade space, you may be able to get about a 50 basis point pick-up in yield versus investment-grade corporates. That represents a good diversifier, or perhaps a complement, at the very least, to your investment-grade allocation in the U.S.
You can do that via EM corporates as well. We happen to like the high-yield space within EM corporates, in terms of being underappreciated for how large and diversified it is within the overall EM debt space. You can get a slightly higher average credit quality in emerging market high-yield corporates versus U.S. high-yield corporates, and at least a 50 basis point pick-up in yield.2
BUTCHER: Why might investors think of allocating specifically to local currency debt?
RODILOSSO: The number one case for investing in EM local currency debt is that average yields in that asset class are over 6%. Number two, many of EM central banks have scope to ease; not all, as some are in tightening mode. But rates overall have room to come in, both short rates and those farther out the curve. Regarding currency, currency risk can be a significant determination of your volatility and returns in the EM asset class. But EM currencies have underperformed for several years. Particularly as commodities got weaker, EM currencies were the negative part of the strong U.S. dollar trade. By contrast, EM currencies have recovered this year. The asset class has performed quite well in 2016 so far, but after the very tough years of 2013 to 2015. Many EM currencies have not gotten back nominally to where they were before, or when considered from the effective exchange-rate point of view. They tend to correlate fairly highly with commodities prices, and I think you have to be constructive, not wildly bullish, on commodity prices, to expect some currency gains.
BUTCHER: What is your outlook for emerging markets fundamentals?
RODILOSSO: Emerging markets overall are still tied to the developed world in many ways, but you've got plenty of stories about emerging economies developing independent domestic demand and more internal markets. But I think it is critical to think about rates and higher rates and the scenarios where we are likely to see in developed markets, perhaps stronger U.S. growth, maybe signs of life out of Japan, and some acceleration of growth in Europe. These are generally good stories for emerging markets. As it stands today, 2016 GDP rates for emerging markets are likely to come in a little higher than expected based on predictions made a year ago. Emerging markets might even expand their spread over growth rates in developed markets. So the emerging market to developed market growth fundamentals, at least, which is a great measure of ability to pay back debt, had been narrowing for a couple of years while commodities were coming off and EMs were having various deficit problems, but many of them have corrected current account deficit issues. This fundamental is key: the EM-to-DM growth spread is favoring EM again. As I mentioned, central banks have maintained pretty conventional policies, and I believe that represents a healthy starting point. Debt levels overall have risen in some quarters of emerging markets, but they are still much lower with lower ratios of sovereign debt to GDP overall, especially when you compare these to ratios 20-25 years ago.
BUTCHER: One last question: what effect would you see higher rates in the U.S. having on emerging markets debt?
RODILOSSO: It depends very much on the timing, the path, and the expectations surrounding a U.S. rate hike. If we associate higher rates in the U.S. with a stronger dollar, obviously EM local currency may suffer in the short term. If we experience higher rates in the U.S. and assume that some of the dollar strength has already been priced in, that might indicate that there is more global growth than expected and therefore higher commodity prices. This is a great scenario for EM fundamentals overall and may help some of the local currencies to perform relatively well. This is certainly also positive for EM from a credit perspective. I think you have to be wary of market technicals at times, and in the very near term, that may include an interest rate hike that the market may not be expecting, or the Fed coming out with a new predicted path that pushes the market adjust expectations higher. This may cause a technical selloff, which as a long-term EM investor, we like to see, because it is an opportunity to come in where fundamentals on a relative basis are improving, and you have the potential to identify some good values.
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1 Source: J.P. Morgan GBI-EM Global Core Index as of 9/30/2016.
2 Source: Based on the yield difference between the BofA Merrill Lynch Diversified HY US Emerging Markets Corporate Plus Index and the BofA Merrill Lynch US High Yield Master II as of 9/30/2016.
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