Investors turning to EM debt

INVESTORS are likely to keep increasing their exposure to emerging-market (EM) debt as concerns over rising government borrowing and budget deficits in developed economies reshape the way global bond markets assess risk.

With developing nations offering relatively healthier

fiscal positions and attractive inflation-adjusted yields, bouts of volatility in US Treasuries are increasingly being treated as opportunities to buy rather than reasons to retreat.

The shift marks a change in how investors approach EM bonds, which have traditionally struggled whenever US interest rates rise or global financial conditions tighten.

A recent Bloomberg report highlighted that money managers are increasingly looking beyond movements in US Treasury yields to assess the underlying strength of developing economies, helping the asset class outperform its developed-market counterparts.

EM bond funds have recorded 12 consecutive weeks of inflows, according to the latest Bank of America Corp (BofA) data based on EPFR Global.

Investors surveyed by BofAa this month also named EM stocks among their top trades, despite yields on most US bonds exceeding 5%.

The continued demand comes as investors contend with a fresh bout of anxiety in global fixed-income markets, driven largely by mounting debt burdens and fiscal deficits across the United States, Europe and Japan.

Higher borrowing costs in these economies are prompting investors to reconsider where they can find returns without taking on excessive exposure to deteriorating public finances.

Better returns

EM bonds have returned nearly four times as much as US Treasuries since the beginning of last year, Bloomberg reported, while EM equity and bond indexes have also outperformed their developed-market peers this year.

Iain Stealey, chief investment officer for fixed income at JPMorgan Asset Management, told an investor conference in London that he sees room for further investment in the asset class.

“I just don’t think people own enough EMs,” he was quoted as saying by Bloomberg.

He further described the sector as among the “most constructive allocations” across the firm’s US$4.3 trillion portfolio.

Stealey added that the firm would “continue to see assets deployed there”.

He also expects the shift away from developed-market government debt to support further gains, as “people are looking to find ways of getting, maybe, out of developed market governments”.

That movement helps explain why the additional yield investors demand to hold EM bonds instead of US Treasuries has barely changed this year, even as investors have sold US government debt.

Another important development is that fund managers are increasingly evaluating EM debt on its own fundamentals rather than measuring its attractiveness mainly against Treasury yields.

Increasing exposure

Peter Kent, co-chief investment officer of fixed income at Ninety One Asset Management, which has recently increased its EM debt exposure, said the approach had helped the firm continue buying bonds even as their relative yields narrowed.

“The one thing we’ve done well over the last 18 months is not use Treasuries as our valuation metric,” Kent told Bloomberg.

“If you had, you would have stopped buying EM eight months ago, when spreads got quite tight.”

The change in perspective reflects improvements in the finances and economic policy frameworks of many developing countries, even as advanced economies face questions over their ability to manage growing public debt.

Guillaume Tresca, global EM strategist at Generali Asset Management, said many developing nations were now better equipped to withstand interest-rate shocks.

“The global credit rating of EM countries is on the upward trend clearly. While on the other side, there have been many questions on developed-market countries, like France,” he told Bloomberg.

Strategists at UBS Group AG noted that budget deficits are smaller on average in EMs than in developed economies.

Many developing countries have also reduced their exposure to fluctuations in the US dollar by shifting more of their borrowing into domestic currencies.

Meanwhile, earlier and more aggressive action by EM central banks to contain inflation has helped preserve relatively high inflation-adjusted yields, according to Milana Muratova of Aberdeen Investments.

These yields have helped support both bonds and currencies despite the dollar’s strength.

“That does not make emerging currencies immune to US dollar strength, but it does underline an important point: domestic fundamentals increasingly matter,” Muratova told Bloomberg.

However, the rally has not removed the risks across EMs, with conditions varying considerably between countries.

India has introduced a series of extraordinary measures to support its currency, while US dollar borrowing costs have climbed towards 10% in countries including Mozambique, Sri Lanka and Ecuador.

Mixed performance

Eric Fine, head of active EM debt at VanEck, said yields on local-currency debt in India, the Philippines and Thailand were not sufficiently attractive.

Instead, he favours riskier but higher-yielding dollar bonds issued by countries such as Venezuela, Ecuador, Bolivia, Nigeria and Ghana.

The distinction highlights how investors are becoming more selective, weighing individual countries’ yields and risks rather than treating EMs as a single investment category.

Desmond Lawrence, senior investment strategist at State Street Global Advisors, attributed part of the asset class’s strong performance to developing nations having less capacity to accumulate debt than advanced economies, which helped limit excessive borrowing.

“The whole dynamic is changing,” Lawrence said. EM debt “will be an asset that’ll get you through the next few quarters. Its resilience has been remarkable”, he told Bloomberg.