A buying opportunity may have come about in emerging market debt given the high yields now on offer, according to M&G’s Gordon Harding, though he says investors should only consider the asset class if they have a long-term outlook and are able to stomach higher levels of volatility.
Emerging market debt has been one of the most out-of-favour asset classes over recent years and since mid-2013 money has poured out of funds which focus on the area.
The reasons for this trend have been well-documented, ranging from slowing growth in several major emerging market economies, the prospect of tighter monetary policy in the US, concerns over current account deficits, currency weakness and falling commodity prices.
All told, they mean emerging market debt has been one of the worst performing areas of the global fixed income market.
For example, the average fund in the IA Global Emerging Market Bond sector has fallen 10 per cent over the past three years, according to FE Analytics.
The sector is also down 18 per cent since May 2013, when a pan-asset class sell-off occurred thanks to hints from the US Federal Reserve that it would ‘taper’ its quantitative easing programme.
As the graph below shows, the asset class has also been hit by the recent sell-off in global markets as a result of China’s growth slowdown.
Performance of sector over 3yrs
Source: FE Analytics, bid-to-bid performance with dividends reinvested between 1 Oct 2012 and 30 Sep 2015
However Harding, who is an investment director at M&G, says this has left emerging market debt very undervalued – especially compared to other areas of the fixed income market.
“It is true that valuations have cheapened up quite a bit during the recent sell-off,” Harding (pictured) said.
“In hard currency terms you've got corporates yielding 6 per cent, on average and the average rating there is BBB – so that is a wider spread if you compare it to traditional BBB corporates. There is definitely a yield pick-up you can get by investing in emerging market credits.”
“Emerging market high yield, again in dollars, is yielding roughly 10 per cent on average. Again, that compares favourably to traditional high yield dollar-denominated debt, which is yielding 8 per cent now.”
However, Harding notes that emerging market debt is cheap for a reason as there are still headwinds facing emerging markets in general.
“The main thing is the macro picture at the moment. It has been deteriorating across different regions and some of the major ones have really been struggling,” Harding said.
“You've got Brazil where inflation is close to 10 per cent, growth has actually moved into recession and the currency is weakening as well. It is a similar situation in Russia and then in South Africa, there are similar issues, Turkey as well. These are all big emerging market economies.”
“Then, to throw something else into the mix, you have China – which has been a big worry over the past few months and has been slowing down as well. This means the macro picture is looking quite poor for emerging markets and we think currency devaluation will continue.”
Nevertheless, in a world of low growth (certainly in the developed world), ultra-low interest rates and low bond yields, Harding says genuine income-seeking investors may want to add to their emerging market debt exposure at this point in time.
He notes, however, that M&G’s fixed income team are only focusing on certain areas of emerging market debt. For example, they are avoiding economies which export commodities or trade heavily with China and, instead, are buying exporters in countries with falling exchange rates, such as Mexico.
“I think we will still see issues going forward, but for investors who are able to accept a little bit of volatility then it could be a regional entry point over the longer term,” Harding said.
While emerging market debt funds have struggled over recent years, those which own high yield developed market bonds have performed very well.
According to FE Analytics, the average fund in the IA Sterling High Yield sector has returned more than 100 cent since January 2009, outperforming the UK gilts and investment grade corporate bonds (as measured by the Barclays Sterling Gilts and iBoxx Sterling Corporates All Maturities indices, respectively) in the process.
Performance of sector and indices since Jan 2009
Source: FE Analytics, bid-to-bid performance with dividends reinvested between 1 Jan 2009 and 30 Sep 2015
Given their longer term outperformance, many market commentators have warned high yield bonds may start to struggle over the coming years. Harding, though, expects the asset class to continue to perform reasonably well.
“I don’t think it is going to perform as well as we have seen post crisis because everything got to extremely distressed valuations after the global financial crisis. After that though in years like 2009, high yield returned between 30 to 50 per cent and those sorts of returns are just not going to happen again anytime soon,” he said.
He says, however, that as the sector has fallen close to 5 per cent since the start of June, high yield certainly looks more attractive than it has done over recent years.
Performance of sector in 2015
Source: FE Analytics, bid-to-bid performance with dividends reinvested between 1 Jan 2015 and 30 Sep 2015
“There has actually been quite a correction over the past year or so in the high yield market, so yields have gone from around 5 or 6 per cent to around 8 per cent in the US,” he said. “They therefore look more attractive on a standalone yield basis than they have done at any point over the past 18 months or so.”
He also says that high yield has other attractive features in the current environment – such as its duration, which indicates bonds’ sensitivity to interest rate movements.
“High yield has the attraction of being a relatively short duration asset class so as we go into a tightening cycle, from the likes of the US Federal Reserve and the Bank of England, then high yield should perform well relative to other asset classes - as long as rates are going up for the right reason,” he said.
On top of that, Harding says default rates (which are usually the biggest risk to high yield investors) are running at 2 to 3 per cent globally. This means they are historically low and Harding expects them to remain low in a world of improving growth.
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