Investors desperate for income have flocked to emerging market bond funds – among the few fixed income options offering a positive real return. Since the beginning of the year, investors have poured £189 million into global emerging markets bond funds, according to Morningstar Direct.
In the month after the Brexit vote, the sector saw the largest inflows since July 2014 with £56 million, as investors looked for income overseas in response to falling gilt yields.
And it is not just active funds which are seeing inflows either; global emerging market bond ETFs saw €508 million of inflows in July 2016 alone, the largest inflows in the past five years. Year to date global emerging market bond ETFs have recorded €1.4 billion total inflows.
ETFs, or exchanged traded funds, are passively run investment vehicles that track an index rather than being actively managed.
In the current low interest rate environment emerging market debt offers significant potential for returns, especially when compared to bonds in developed markets, Colm McDonagh, head of emerging markets at Insight Investment said.
Looking at 10-year government bond yields across the global market, in the UK a 10-year gilt currently yields 0.64%, while in the US a 10-year treasury yields 1.57%. Japan and Germany 10-year government bond yields have both fallen into negative territory at -0.08% and -0.07%. Meanwhile, looking at emerging markets in Latin America, a Brazilian 10-year government bond yields 12.06% while a Mexican government bond yields 5.81%.
“Historically, investors have tended to under allocate to emerging market debt due to fears of excessive volatility and potential drawdowns,” McDonagh said, “After a sustained period of market volatility, certain emerging markets’ economies are starting to bottom out while growth forecasts and differentials are improving.”
Morningstar investment professionals showed their preference for emerging market debt when asked about where they would be investing their personal ISA allowance in March this year.
“There have been some interesting pockets of value opening up in the market,” Edward Fane, portfolio manager for Morningstar Investment Management said. “I’d be looking to invest in emerging market debt including the local currency side, as well as emerging market equities.”
Will a US Rate Hike Halt the Bond Rally?
Last week the head of Federal Reserve Janet Yellen said at the central bank’s meeting in Jackson Hole, Wyoming, that economic growth and a stronger jobs market meant "the case for an increase in the federal funds rate has strengthened in recent months", fuelling expectation of an interest rate hike. This raises a question whether an US interest rate rise would affect the positivity so far in emerging markets.
“We do not think emerging markets are seriously threatened by the prospect of a Fed hike,” Jan Dehn, head of research at Ashmore commented.
“Earlier this year the markets had priced in three Fed hikes and emerging market currency was still up versus the US dollar, while emerging market bonds strongly outperformed developed market bonds.”
Dehn does not expect a strong adverse reaction in emerging markets ahead of the next Fed interest rate rise, adding that instead he expects emerging markets to perform strongly.
While the US central bank signals a potential rise in interest rates, other developed countries, most notably the Bank of England and the European Central Bank are still pursuing quantitative easing, putting downward pressure on UK and European bond yields.
The Bank of Japan’s governor, Haruhiko Kuroda, also restated at the Jackson Hole meeting that they would not hesitate to take further stimulus measures in order to meet the 2% inflation target.
Against these backdrops, the environment of lower-for-longer interest rate and bond yields are likely to continue, which may encourage investors to continue to seek out higher-yielding bonds in emerging markets.
Which Funds are Investors Buying?
There are four emerging market bond funds that top the flows chart. All of those four funds have gained more than 20% so far this year and they are investing mainly in emerging Europe and Latin America bonds markets.
Legal & General Emerging Markets Government Bond USD Index saw £117million inflows from January to July 2016, making it the most popular global emerging market bond fund in the year so far. The fund gains 28.8% year to date and its top bond holdings focus on Russia, Argentina, Brazil and Mexico.
Standard Life Investment Emerging Market Debt also recorded £43 million inflows in the first seven months of 2016. The fund earns 27% year to date and it has 12.36% three years annualised return. Its main bond holdings focus on emerging Europe.
M&G Emerging Markets Bond came third in the fund flows list with £39 million. The fund has a 26.6% return year to date. It has a heavy weighting in bonds issued in Brazil, India and Indonesia.
First State Emerging Markets Bond also saw £20 million inflows at the same period of time. The fund has a 27.5% return year to date and a 14% three years annualised return. It has a regional bias towards bonds issued in Russia.
