Emerging markets debt has surged in price. Local-currency debt, represented by the J.P. Morgan Government Bond Index-Emerging Markets, jumped more than 14% in the first eight months of 2017, while hard-currency debt rose 9%. Those increases far outpaced the Barclays Bloomberg US Aggregate Bond Index, which returned just 3.6% in the period.
Asset flows paint a similar picture. Investors who fled emerging market debt late last year returned en masse this year, as asset flows to both local and external emerging market debt have approached record highs throughout 2017. The predictable result has been lower yields, in both absolute and relative terms, and the outsized returns already mentioned. But where has this rally left the asset class in terms of attractiveness from a valuation perspective?
Looking under the hood, we continue to find the yield on local-currency emerging markets debt compelling. The index was yielding more than 6% in nominal terms at the end of August, which is down by a percentage point since the start of 2016, but still appealing relative to history.
Our enthusiasm for this asset class is tempered, however, by emerging markets currencies as they’ve rallied over 7% versus the US dollar since the end of November 2016, and with a volatile performance profile, we could easily see this reverse.
The same is not true with hard-currency emerging market debt. As these are generally tied to the US dollar, a swift currency decline is not such a danger. However, the spread between the current yield and the US Treasury yield has fallen to 3%, which is below our fair value spread of 3.4% and a good drop from the 4.6% spread in January 2016. For this reason, we no longer feel that hard-currency bonds offer a compelling risk-reward tradeoff.
How Markets Have Performed
At the beginning of 2016, we saw an opportunity in emerging markets debt based on valuations. In 2015, a commodity bust, along with structural issues such as high inflation, disappointing growth, and political turmoil in some countries, had put a 25% dent in the Bloomberg Commodity Index, which contributed to an almost 15% drop for both emerging market equities and emerging market local-currency debt. Hard-currency emerging market debt held up somewhat better, although it returned a paltry 1% in 2015.
Yet, declines weren’t constrained to 2015. Local-currency bonds had also notched up substantial losses in 2013 and 2014, driven in part by the almost 35% rise in the US dollar versus the currencies in the local-currency emerging market debt index.
This sustained pounding of emerging market debt inflated the index’s yield to 7.1% by the end of 2015. Attractive yields combined with competitive exchange rates led us to believe the reward for risk looked attractive.
The question was whether the opportunity would help portfolios and in what size. Distinctively, beaten-up asset classes often present buying opportunities for valuation-driven investors like us who look for chances to buy assets investors have fled, as depressed prices typically offer greater potential for future return. We were therefore willing to take a contrary stance if it would help our portfolios to achieve better long-term outcomes.
Bringing Us to Today
Emerging market debt is not nearly as attractive as what it was back in early 2016, however we still believe local currency debt warrants an investors attention. This is especially true on a relative basis, where we can see strong valuation-implied returns for local currency debt relative to many other markets.
We note, of course, that returns must be balanced with an appropriate risk assessment. In this regard, one must be careful with emerging market currency risk – as it has a strong tendency to fall during times of stress – and the asset class has a higher correlation to equities through the cycle. Therefore, even though the local currency asset class warrants a “Medium” conviction overall and hard currency debt a “Low to Medium” conviction, both of which are higher than any other fixed income asset, sizing must reflect the inherent challenges faced to ensure portfolio outcomes are managed appropriately.
