Emerging-market debt – especially in local currencies – has been out of favour in recent years but is starting to attract attention again, and for good reason, says Jan Dehn, head of research at UK fund manager Ashmore. He cites five arguments why he thinks local-currency EM bonds will be the best-performing asset class this year.
The first is that yields are very high, after EM debt has been “beaten up” for several years. As a result, investors are being well paid for taking EM debt risk – far more so than on developed-market bonds.
Dehn's second point is based on fundamentals. “Let’s say you were an ancient Greek-style god and in a fit of pique you wanted to go about destroying emerging markets. I suggest you’d start with a taper tantrum, drop commodity prices by 60%, throw in a 50% dollar rally, then have a US interest rate hike – that should do it.
“Well we’ve just had all that, and EM debt has survived," he said. "We’ve not had a single sovereign default in emerging markets due to any of those shocks. There were two defaults: in Ukraine – because it’s at war with Russia – and Argentina, which was a technical default. Neither were related to the global shocks I mentioned.”
In fact, corporate default rates in emerging markets are lower than in the US, Dehn said. “So all this talk of FX mismatches causing massive defaults in EMs has not been substantiated.”
Instead, EM currencies have fallen 40% against the dollar, according to JP Morgan’s EM spot FX index. That means EM bonds have become much more competitive than developed-market ones, he noted.
Dehn’s third point in support of EM bonds is that some developed markets are “starting to look a little dicey”. In the US, the shale gas sector is suffering because oil is so cheap, the manufacturing sector is in recession and exports are not so competitive any more thanks to the soaring dollar.
Plus the European banking system is starting to look a little problematic in light of the move to negative interest rates, he added. “There are some fundamental reasons to be uneasy on DMs that we haven’t seen in a little while.”
Argument number four is that valuations in DM bonds “are ridiculous”, said Dehn. “We’ve pumped up and re-inflated [through stimulus measures such as bond-buying] to the point where about half of European government bonds have negative yields, and so do Japanese government bonds.”
The final, clinching factor is that the dollar is stabilising against EM currencies. “Effectively, the greenback drives EM local-currency bond flows," noted Dehn. "If it goes up as it has done for the past four years, it doesn’t matter if a local-currency EM bond pays 7% if that currency is down 10% against the dollar.”
However, the dollar has been stabilising; EM currencies are up 2.3% versus the greenback this year, according to JP Morgan’s EM spot FX index. Hence investors are getting paid a much higher yield for much shorter maturities than the average duration in developed markets – and they are not losing on the exchange rate.
“If you add up all these factors, I think the best performing asset class this year will be EM local-currency bonds, and the best performing of those will be Brazil,” said Dehn.
The question is whether investors actually buy into it, he added. “You can wave the carrots of value and fundamentals in front of investors, but what is luring people back into EMs is not so much the value proposition, but the fact that DMs are not producing returns.”
Dehn is not alone in his support for EM bonds. UK hedge fund manager Man Group has decided that now is a good time to build capabilities in this area, having hired its first dedicated head of EM debt in January. And Chinese investment group Fosun's fixed income CIO said this month the firm was overweight EM high-yield bonds (in dollars) for its $24 billion insurance asset portolio.
However, the Institute of International Finance (IIF) in mid-March pointed to the growing leverage in EMs and the risks it posed. Debt continued to rise in emerging markets across all sectors, by $1.6 trillion to $62 trillion last year, around 210% of GDP, according to the Washington-based group.
While this was a slower pace of accumulation than in 2014, refinancing risk has risen, it added. The IIF said $730 billion of bonds issued by EM governments and companies were due for repayment in 2016, and another $890 billion matures next year, a third of it in US dollars.