Investors should consider the high yielding emerging market fixed income space to be a significant value trap, according to City Financial’s head of multi-asset Mark Harris.
For more than two years funds buying the credit and sovereign debt of emerging market countries, taken on average, have been mostly losing money for investors rendering the asset class to be highly unpopular both with fund managers and their underlying clients.
The ‘out-of-favour’ era was prompted by a the taper tantrum of 2013 when the market panicked over comments from then Federal Reserve chair Ben Bernanke that he would start to ‘taper’ its $85bn a month quantitative easing at some point in near future.
According to FE Analytics, the IA Global Emerging Market Bond sector average is down 15.53 per since October 2012.
Performance of sector since June 2013
Source: FE Analytics
The falls over this period – shown in the graph below - have pushed up yields significantly and tempted some back to the asset class due to the contrasting low yielding bond market in the developed world.
However, Harris thinks the mounting unease in emerging markets this year, which saw the asset class sell off, will spell further trouble due to three factors: the strength of the US dollar, weakening global growth and dwindling commodity prices.
Harris (pictured) said: “We have been warning for some time that many emerging market bond and credit markets are likely to suffer as countries and companies struggle with the effects of the strong US dollar, weak global growth and weak commodity prices.”
He thinks a particular problem has been the structural increase in debt across the developing world over the past decade.
“It is evident that issuance of local and hard currency debt in emerging markets has markedly increased in recent years, with domestic loans and locally issued bonds of companies ex China moving up from $3.5trn in 2008 to $6.3trn currently.”
“It is no surprise that the International Monetary Fund has issued a double warning over higher US interest rates, which it said could trigger a wave of emerging market corporate defaults and panic in financial markets as liquidity evaporates.”
Debt levels in emerging markets have exploded over the past decade at the national, corporate and household level, but particularly in the largest and most important economy; China.
Coupling this with economic growth slowing in many emerging market countries and a commodity sell off in some of the largest such as Brazil and Russia – he says there are plenty of risks.
“China is experiencing a hard landing and the Chinese equity market now reflects this issue to a major extent. We maintain that their credit issues can be contained but more extreme stimulus measures will be deployed, including a large fiscal programme.”
However, over this period it has not been all doom and gloom for funds in the sector. Candriam Bonds Emerging Markets, Fidelity Emerging Market Debt, M&G Emerging Markets Bond, Invesco Emerging Markets Bond and Pictet Global Emerging Debt have all had a good run over the period shown in graph above with positive returns.
Source: FE Analytics
Of these five funds, which are also all top quartile this year, it is interesting that they have also all only lost cash in two full calendar years out of the last 10: 2013 and 2006. In these two years all of them lost money, in the high single digits in 2013 and low single digits in 2004.
Emerging market debt can also be a useful volatility dampener as well as providing a good yield, particularly in the cases of Brazil and Mexico, says manager of the £330m M&G Episode Income fund Steven Andrew.
“There are opportunities in emerging market debt that we have been nibbling at. None of them are massive positions but with one worried about the effect of when the Fed raises rates has meant this risk is reflected in the price ,” Andrew said.
“Brazilian government debt has sold off sharply …as has Mexican government debt both to levels that are weaker than after the peak in rates in 2013.”
David Absolon, investment director at Heartwood Investment Management says economic fundamentals have worsened generally across the asset class for both hard and local currency markets as financial conditions have tightened in many emerging countries.
In particular because of dollar strength relative to emerging market currencies, shown in the graph below relative to the Chinese Renminbi.
“Over the last year we have taken a cautious view of the emerging market debt asset class, given our concerns about the strength of the US dollar and perceptions of Federal Reserve tightening.”
“We retain our cautious outlook over the next six months, but also recognise that central banks in emerging markets will be better positioned to continue with their programmes of supporting growth and inflation as we see more certainty surrounding Fed policy.”
Performance of dollar versus Chinese Renminbi over 2yrs
Source: FE Analytics
"Should the strong US dollar trend stabilise, over the longer term this market should begin to show more interesting opportunities,” Absolon added.