Q&A: What's the story with emerging-market bonds?
As world markets continue to digest the Federal Reserve’s plans to scale back its bond buying, investor risk aversion has resurfaced in a big way. Not surprisingly, emerging-market debt, one of the best-performing segments in the bond market over the past few years, has been strongly affected by this negative sentiment. Is it all about the Fed? Can investors still find value in emerging-market bonds? We asked Ihab Salib, senior portfolio manager and head of Federated’s International Fixed Income Group, for his perspective.
Q: Emerging-market bonds have experienced outsized volatility recently. Why? Like all fixed-income assets and most financial assets in general, U.S. rates have been a key driver of the recent volatility. Even before the Fed’s most recent statement, emerging-markets bond prices and yields were highly correlated to U.S. rates. Keep in mind; this is an investment grade asset class, so you can expect this level of correlation.
We can divide year-to-date performance into four segments:
- From early January through the end of the first quarter, the U.S. dollar-denominated emerging -markets fixed-income index (J.P. Morgan Emerging Markets Bond Index Global) was down approximately 2.5%, mostly due to U.S. rate volatility. As U.S. rates went up, bonds prices declined. There was also some spread widening in most sectors and regions. At this point, the market was starting to price in some pullback in the Fed’s quantitative-easing policy.
- In early April, the Bank of Japan announced its long-anticipated monetary policy change, which the markets perceived as more stimulative than expected. As a result, higher-yielding asset classes performed very well, including high-yield bonds, European peripheral bonds and emerging-market bonds. The emerging-markets index moved up about 3.5% from April to early May, erasing year-to-date losses with a net gain of about 1%.
- A first round of comments in May by Fed Chairman Ben Bernanke put all risk markets on edge as he suggested that the policy-setting Federal Open Market Committee (FOMC) was open to reducing the scale of the Fed’s extremely accommodative monetary policy.
- Finally, the June 19 FOMC meeting confirmed policymakers’ intentions of winding down their monthly $85 billion in longer-term bond purchases, and a more definitive timetable for doing so was provided. This further rattled the markets, resulting in higher U.S. rates and a corresponding sell-off in emerging-market bonds and all other fixed-income sectors.
Q: What should we expect now for emerging-market bonds? It’s important for investors to consider what has been driving financial asset prices. Was it only the low interest-rate environment supported by Fed policy that drove investors to higher-yielding emerging-market bonds? Or was it a combination of factors including stronger economic conditions in the U.S., a more stable picture in Europe and, most importantly, substantial fundamental improvements in emerging-market economies over the past several years?
One way to look at emerging-market economies is as a train with two engines. The first—and historically main engine—was tied to exports (commodities and low-cost consumer goods). As long as there was strong demand for emerging-market goods by the developed world, that engine ran smoothly. Since the financial crisis, this first export engine slowed considerably because of the subsequent global economic slowdown. But it has more recently picked up in response to an improving U.S. economy, more stability in Europe and Japan’s massive new stimulus program.
Increasingly, a second engine has been driving emerging economies: a rapidly growing middle class. This rising middle class has brought about greater economic diversification with more focus on domestic services and consumer spending and less dependency on commodity exports. Because emerging markets were much less affected by the financial crisis due to their low debt levels and growing economies, they have been performing strongly and, in fact, supported developed economies during the downturn. Over the past year, there has been some slowdown in the emerging markets’ own domestic economies, partially a result of the extended subpar economic performance in much of the developed world prior to the most recent uptick. Overall, however, the emerging markets’ domestic engines remain quite stable.
Bottom line: those who give the Fed full credit for performance in the emerging-market debt class are likely to expect—incorrectly, we believe—a lot more volatility and downside risk. Our view is that Fed policy accelerated performance in the asset class, but over time, these other key, more fundamental factors came into play. While more volatility is likely, there’s also good reason to expect less downside risk.
Q: Will emerging-market bonds suffer if U.S. rates continue to rise? If the U.S. 10-year Treasury yields stabilize at around 2.5% to 3%, as we believe they will, emerging-market bonds will continue to perform well. As noted, there will be some further volatility, but our view is that we’ve already experienced 60% to 80% of the impact already. In the unlikely scenario that U.S. rates head significantly higher, there will be more downside in all fixed-income assets, including emerging-market debt.
Q: Can investors still find value in emerging-markets bonds? Yes, for two reasons.
First, consider that on average, the asset class has experienced approximately a 2% upward movement in yield over the past six to eight weeks. Half of that yield increase was related to the rise in U.S. interest rates. For example, the 10-year Treasury went from 1.6% to 2.5%. The other half of the increase was due to widening credit spreads. So, an emerging-market bond that was yielding 4% prior to the recent sell-off is currently yielding about 6%.
Second, keep in mind that U.S. rates are expected to remain low per Chairman Bernanke’s clarification regarding timing for any increase in the fed funds target rate. However, any target rate increase will depend on strengthening economic fundamentals in the U.S., which in turn support the economic outlook for emerging economies.
We believe most investors would agree that a 6% yield for an investment grade asset class in the current environment represents good value. This is especially true when you consider that from a fiscal standpoint most emerging economies remain in much stronger position compared to their developed country counterparts. Long-term investors stand to benefit by using the downside to add to their emerging-market bond positions.
Thank you, Ihab.