Yield-starved asset managers see attractive relative-value opportunities in EM debt market as spreads stay wide

Emerging markets

Asset managers say it is time to embrace riskier fixed-income assets again, with emerging markets bonds becoming an increasingly attractive option for investors as optimism wanes over a quick economic recovery in developed markets.

Emerging market economies are expected to withstand the shock from coronavirus better than developed markets. The IMF forecasts less than half the contraction in growth in 2020 compared with developed markets, and faster growth continuing into 2021. 

Investor appetite for risk assets, including emerging markets fixed income and equities, has remained low since the coronavirus sell-off in March, when investors began pouring into ‘safe haven’ assets like US Treasuries and money market funds.

Some investors are now seeing risk-aversion towards emerging markets as overblown, given the increasingly attractive yields and growth prospects. 

“Emerging markets bond yields appear unusually high compared to yields in developed markets despite the months-long rally,” says Jan Dehn, head of research at emerging markets specialist Ashmore Investment Management. 

Dehn estimates that a typical five-year investment grade government bond in emerging markets has a real yield of 2.1 per cent, which “compares extremely favourably to the real yield on a US 5-year government bond of about -0.9 per cent, implying a real yield pick-up of 3.2 per cent.”

He expects that emerging markets sovereign debt spreads will return to the pre-coronavirus level, meaning emerging markets sovereign bonds should benefit from “at least another 6 per cent return over and above the yield”.

Wide debt spreads are also making high-yield emerging markets sovereign debt “attractive relative to US high-yield corporates” with a lower chance of default, according to a recent market outlook from Lazard Asset Management.

“Emerging markets debt spreads have outperformed recently, but the spread pick-up remains near historical highs at just over 200 bps currently. Moreover, while we expect to see an increase in emerging markets defaults in 2020, our default rate forecast is relatively muted, and most of these defaults have either already occurred or are priced into the market. 

“In contrast, defaults in US high yield are expected to reach the high single digits this year due to significant exposure to troubled industries such as shale oil production, retail, and travel and hospitality.”

The current differential between emerging and developed market bonds, according to Dehn, “likely reflects lingering uncertainties about how the pandemic will evolve, fears of continuing economic weakness in many parts of the world, and the escalation of America’s witch hunt against China in the run-up to November’s presidential election”.

Moreover, looser monetary policy is likely to be a boon in emerging markets, with American asset manager Invesco saying that it will open up new opportunities in local government emerging markets debt.

Central banks, including South Africa, Indonesia, and Brazil, have all been making emergency interest-rate cuts since March in an attempt to shore up their economies as the coronavirus pandemic took hold.

“The greatest seismic shift has occurred in emerging markets where interest rates have been lowered to record lows and risk premia have shifted from currency risk to term premia (additional yield earned for holding longer-maturity bonds),” says Hemant Baijal, senior portfolio manager and leader of the global debt team at Invesco. 

Invesco says this is making local government bonds “competitive for the first time in years” against five-year BBB rated US dollar-denominated corporate bonds.

“EM central banks are likely to continue to ease policy interest rates, adding to the significant number of rate cuts that have already been delivered. EM central banks have delivered, on average, around 150 bps in total interest rate cuts since the beginning of March 2020. While we are at lower bounds in some EM, we believe there is room for additional cuts in many others, such as Mexico, India and Indonesia,” says Baijal.

Ashmore estimates that by 2025, the EM fixed income market will grow to be worth USD45 trillion, corresponding to 29 per cent of the total global bond market.

Despite this, emerging markets remain “severely under-financed”, says Dehn, as their bond and stock markets are jointly smaller than GDP, while in developed economies they are roughly 3.6 times larger than GDP. 

“The extent of under-financing in EM means that supply is likely to be constrained by demand for many years. This may be bad for EM issuers, but it is positive for bond holders, since they get paid more yield than the risk they take.”