Since the end of October, emerging market dollar-denominated corporate bonds have lost around 2 per cent, driven by the poor performance of corporate debt issued in Latin America and the Europe, Middle East and Africa region.
Funds investing the asset class have struggled to get ahead. As the graph below shows, the average fund in the IMA Global Emerging Market Bond sector has lost more than 4.5 per cent since a peak at the start of September, taking the year to date total return to just 4 per cent.
In contrast, the best performing fixed income sector - IMA UK Index Linked Gilts - has made close to 20 per cent over 2014 so far while global equities, represented by the MSCI AC World index, have risen 9.10 per cent.
Performance of sectors and index over year to date
Source: FE Analytics
A number of reasons have been suggested for emerging market debt’s (EMD’s) recent lacklustre performance but the standout contributor has been the strength of the dollar.
The rise of the dollar has made it harder for yield-hungry investors to come by easy returns. Since the start of autumn, the dollar has risen 18 per cent against the Brazilian real and 43 per cent against the Russian rouble.
Investors have fled the asset class in recent months because of these concerns. Data from Bank of America Merrill Lynch and EPFR Global shows $1.1bn was pulled out of EMD funds worldwide last week, while IMA data shows funds domiciled in the UK posted net retail outflows in October.
John Higgins, chief markets economist at Capital Economics, says returns have been easier to come by in other parts of the fixed income market but argues that the recent underperformance of emerging market bonds, especially of corporate bonds, could start to reverse.
“Since the end of October, emerging market dollar-denominated corporate bonds have performed much worse than comparably-rated US corporate bonds,” he said.
“This has been the result of increasing credit spreads amid concerns that the significant rise in the international debt of emerging market corporations since the last recession makes them vulnerable to a stronger dollar.”
However, Higgins adds that the spreads between emerging market corporate bonds and US corporate bonds are tipped to fall than rise in the months ahead, as the currencies of countries that have issued the most debt are unlikely to depreciate much further.
“Indeed, the currency of the country where issuance has been largest – China – will probably continue to appreciate,” he continued. “What’s more, the valuations of emerging market corporate bonds are relatively low, which reduces the downside risk.”
Luca Paolini, chief strategist at Pictet Asset Management, says EMD remains his favourite pick in the fixed income market and is overweight both local currency and hard currency bonds.
A driving reason behind Pictet’s confidence in the asset class are the recent moves by the People’s Bank of China to stimulate the world’s second largest economy. Earlier this year the central bank injected liquidity into the banking system, in a bid to encourage lending.
Paolini said: “The prospects for local currency debt look especially promising now that China has shifted to a more dovish monetary stance, which should begin to provide support for the asset class. Indeed, we believe China is at the beginning of a rate cut cycle.”
“Monetary policy should also provide some support - we believe a growing number of emerging market central banks will shift to a more accommodative stance in the wake of China’s move to underpin its economy.”
The strategist also thinks emerging market currencies should soon begin to recover from their depreciation against the dollar. Pictet’s models suggest emerging currencies are trading two standard deviations below fair value but expects this to “start to disappear” in the coming months.
Andrew Wells (pictured), global chief investment officer for fixed income at Fidelity Worldwide Investment, thinks investment grade credit remains the “sweet spot” of bond markets but expects investors to look to other areas, such as EMD and high yield, over the year ahead.
“With the hunt for yield still in full swing, emerging market bonds should be a key beneficiary, offering optically striking yields versus most other areas of fixed income,” he said.
“Asia has an increasing role to play as part of this. Indeed, China RMB bonds have been a standout performer in 2014, up by more than 3 per cent year to date, while exhibiting much lower volatility than the rest of the EM bond universe. Offering yields in excess of 4 per cent with investment grade risk, it is an alluring proposition and powerful diversifier.”
However, Wells warns that liquidity should the main concern of investors in niche parts of the market, such as emerging market bonds, high yield and more esoteric areas such as hybrids. In light of this he recommends a barbell strategy that sits these investments alongside highly liquid assets as sensible.
When it comes to investing in pure EMD funds, investors have to bear in mind that it is a relatively new and small sector in which to go hunting - the IMA Global Emerging Market Bond peer group was only created at the start of the year and houses 27 funds with total assets of £3.1bn.
None of the funds appear on the FE Research team’s Select 100 or in Square Mile’s Academy of Funds. However, FE Alpha Manager Matthew W Ryan works on two funds - MFS Meridian Emerging Markets Debt and MFS Meridian Emerging Markets Debt Local Currency.
Meanwhile two funds have earned FE Crowns in recognition of superior performance in terms of stockpicking, consistency of outperformance and risk control over recent times. These are the Pictet Global Emerging Debt and Aberdeen Emerging Markets Bond, which as the graph below shows have both comfortably outperformed their average peer over the past three years.
Performance of funds and sector over 3yrs
Source: FE Analytics
