Seventy per cent of developed market government bonds now yield less than one percent, according to JP Morgan figures. Indeed, 30% of them offer negative yields – so you have to pay to lend out your hard earned cash. Those statistics are almost worth repeating; they’re as good a clue as any as to how challenging the economic climate is, and how difficult life has become for an income investor.
In Europe, with central bank deposit rates at -0.4%, the situation is even worse (over 80% and 45% respectively); and that is before inflation is factored in. Recent political events in the UK and Europe point toward this situation continuing for quite some time.
Investors are therefore being led out of their comfort zones. One worthy place it has started to lead them to so far this year is emerging market bonds. And with yields of over 6%, it’s easy to see why.
Emerging market valuations stand out
Sovereign: JPM EMBI Global Diversified Index; EM LC Sovereign: JPM GBI-EM Global Diversified Index; DM Sovereign: JPM GBI Global Index Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. Individuals cannot invest directly in an index. Source: JP Morgan, August 2016. For illustrative purposes only. Past performance is not a guide to future results.
The reason the shift hasn’t happened sooner is purely down to sentiment.
The reason the shift hasn’t happened sooner is purely down to sentiment. The now infamous ‘taper tantrum’ back in the summer of 2013 triggered by then US Federal Reserve Chairman Ben Bernanke’s hints at a tightening of monetary policy caused emerging market currency markets to convulse. Until recently these markets were unable to recover as continued dollar strength, worries over China (particularly its economic health and manipulated currency value) and a sharp drop in commodity prices hit investor confidence.
So what has changed, and why are emerging markets, particularly local currency bonds, now an attractive prospect?
Firstly: default rates.Typically higher yields mean higher risks, and therefore defaults. As a rule of thumb to live by, investors never go too far wrong with this logic. However, no emerging market country has defaulted on a bond issued in its domestic currency since Russia in 1998. It would be disingenuous to imply that such a trend can be extrapolated forward, but it does give you a flavour of both the ability and willingness to pay of emerging market issuers. On the former, governments’ ability to service its debt is much higher for local currency debt as it can raise revenue in its local currency (hike taxes, sell assets) or make the central bank to print money (monetize the debt). Therefore, defaults occur predominantly in hard currency, as a sovereign’s ability to raise foreign currency revenues is much more limited.
Furthermore, harsh lessons were learnt in 1998, and not just in Asia but in the broader emerging markets as well. Financial regulation, in general, has improved while central banks have larger cash reserves and built up their institutional credibility.
Secondly: resilient response. Emerging markets faced a twin shock of weaker global trade and lower commodities prices, but many countries have responded. As a result, external balances have improved for many previously fragile countries and fiscal positions are more solid. On policy front, countries from Russia to Mexico have cut their budget expenditures, others like Indonesia and Malaysia eliminated fuel subsidies, some like India and Hungary have introduced new taxes.
Thirdly: Currencies.Valuations have changed a lot. This is because they’ve largely been driven by sentiment and not underlying fundamentals. The drop in currency values since mid-2011 was dramatic; JP Morgan’s emerging market currency index fell by almost 40% between June 2011 and January 2016, but has since rebounded 8%. So even when you factor in a small recovery year-to-date, it’s hard not to conclude that much of the perceived ‘bad news’ is already priced in.
Fourthly: Politics. Nobody’s perfect. Paradoxically, emerging markets are used to dealing with political uncertainty. It has always played a major part of the investment decision process. Developed markets, however, have seen things change considerably over recent years. The UK’s decision to leave the EU is the latest and arguably most vivid example of this. The US presidential election also springs to mind, as does the Eurozone’s perpetual existential crisis.
What’s more, structural demand for emerging market bonds seems set to flow from developed markets as income-hungry investors are forced by central banks to venture further afield. Furthermore, as the domestic middle classes grow in terms of size and wealth a further source of demand will emerge, one that you would intuitively think would be ‘stickier’ and less flighty than foreign capital.
Investors remain underexposed to the asset class, and in a world starved of income this seems curious. With alluring yields and little, if any, sacrifice in credit quality, emerging market local currency bonds represent an interesting opportunity.