Investors worried about the excessive price tag on fixed income assets after a bull run lasting 30 years may want to consider emerging market debt as this sector is “screaming value”, according to Justin Onuekwusi, head of retail multi-asset funds at Legal & General Investment Management (LGIM).
IA Global Emerging Markets Bond was one of the best-performing fixed income sectors in the 10 years to the start of 2018, its gains of 102.34 per cent even ahead of the 84.49 per cent made by the FTSE All Share.
Performance of sector vs index over 10yrs
Source: FE Analytics
However, it is in negative territory over the past year, with the speed of the Federal Reserve’s interest rate hikes leading to tighter dollar liquidity conditions. While most bond sectors have struggled in this environment, LGIM's head of emerging market debt Uday Patnaik said his area of focus is currently offering “some of the juiciest yields we have seen in over five years”
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“The yields right now have backed up significantly: you’re getting a yield of about 7 per cent in US dollars in sovereign debt and about 6.5 per cent or so in hard currency-denominated corporate debt,” he explained.
“Over the last eight years this is the cheapest emerging market debt has been to US high yield and the cheapest emerging market debt has been to US investment grade bonds.”
Patnaik also noted that the emerging market debt sector was the first to re-price following this year’s multitude of headwinds. Yet he said the “beauty” of the asset class now is that the high single-digit yields on offer are already pricing in the high-profile challenges it is facing, whether that is the slowdown in China or the crises in Turkey and Argentina.
“When we talk to investors, a lot of them are still looking for yield,” the manager continued. “So you know, if you look at bunds for example, out to seven years, they are still offering negative yields. Gilts don’t offer you much of anything.
“But you can buy hard currency-denominated emerging market debt at the widest, highest yields today versus five or six years ago.”
He added: “It is important to look at emerging markets from a top-down macro approach: in 30 years of investing, I have never seen a manager consistently make money in emerging markets without this approach.
“If you believe the Fed is nearly done with its tightening cycle, that emerging markets have done the majority of the repricing, my base case scenario for 2019 is that emerging market hard currency debt will return somewhere between 4 and 7 per cent.”
Speaking from a multi-asset perspective, Onuekwusi said that while he is overall negative on the fixed income asset class, he doesn’t believe in completely selling out of bonds in the way many of LGIM’s competitors do.
“We believe in diversifying over that bond spectrum and then trying to be active in terms of asset allocation,” he explained.
“One area we really like is emerging market debt. As capital reserves have been built up over recent years, the default risk in hard currency denominated debt has fallen.
“On the hard currency side, emerging market debt for us is screaming value.”
LGIM’s managers are not the only ones who think a buying opportunity may have opened in emerging market debt. In a recent article on FE Trustnet, Brewin Dolphin's head of research Guy Foster said investors’ lowest weighting to this asset class for five years makes it a good contrarian play.
However, while Patnaik said the short-term prospects for emerging market debt look compelling, it is the long-term macro drivers behind the asset class that he is most excited about.
The manager pointed out that when he started his investment career in the early 1990s, emerging market economies accounted for approximately 20 per cent of global GDP in dollar terms; today, it is 42 per cent. In terms of purchasing power parity, emerging markets account for 60 per cent of global GDP.
“Now, what’s really interesting is that fairly recently PWC and the IMF did an analysis looking at emerging markets versus developed markets out to 2050,” he continued.
“By the end of this year, of the top-10 economies in the world, five will be emerging markets, measured by purchasing power parity. By 2030, six of the top-10 economies in the world will be emerging markets and if you extrapolate that to 2050, six of the top-seven economies in the world will be emerging markets.
“This theme has been incredibly durable for the past three decades and I suspect it will continue to be so.”
Data from FE Analytics shows Patnaik’s L&G Emerging Markets Short Duration Bond fund has made 4.53 per cent since launch in May this year compared with 0.56 per cent from its Offshore Mutual Fixed Interest Emerging Markets sector.
Performance of fund vs sector since launch
Source: FE Analytics
The fund is $184.5m in size and has ongoing charges of 0.06 per cent.