Emerging Markets (EM) Bonds?

The prevailing environment of uncertainty over the prospects of the world economy has led investors to seek lower risk investment opportunities and that has led to an increase in the demand for government bonds which pushes their prices up. If the price of a bond goes up, its yield goes down.

Search for yield

But much of the demand stems from the economic stimulus measures enacted by central banks, i.e. quantitative easing. This involves electronically “printing” money to buy bonds that tend to carry lower levels of risk such as government bonds and high-grade corporate bonds. In the UK, the yield on government bonds recently fell to an all-time low of 0.51%, while German Bunds yields dipped into negative territory.

According to figures from JP Morgan, 70% of government bonds currently yield less than 1% with 30% of them delivering negative yields i.e. the investor is effectively paying to hold the bond.

With yields being pushed down so far, investors might buy bonds with lower credit ratings in order to obtain investments that are more likely to generate reasonable yields. And this is where emerging market bonds enter the picture. At the end of August, emerging market government bonds provided a yield of 6.3%.

But why is this shift of appetite happening now?

Government finances improve

One reason is the way in which governments have responded to weaker global trade and lower commodity prices. Russia and Mexico have cut their budget expenditure, Indonesia and Malaysia have eliminated fuel subsidies, while India and Hungary have introduced new taxes. This has improved their respective positions in terms of imports and exports as well as boosting the financial health of their governments.

Currencies recover

A further reason comes in the form of emerging market currencies rising in value relative to the US dollar. Between the start of the year and 31 August, the JP Morgan emerging markets currency index has increased by around 3.7%. But it is still down by about 36.5% from its peak in the middle of 2011. Predicting the movements of currencies markets is notoriously difficult, but a continued rise in emerging markets currencies should benefit investors that hold bonds issued in the currencies of these countries.

Investors move in

These factors have combined to drive $18bn of new investments into EM bonds in July, according to the Wall Street Journal and data service EPFR. Such is the recent demand for EM bonds that there is now some concern that it’s gone too far and prices could drop sharply.

In our opinion, however, the demand is sustainable and is being driven by the improving finances of issuing governments. What’s more, yields of EM bonds are very attractive in comparison to developed market equivalents especially as QE measures seem set to continue to maintain upward pressure on prices and, therefore, low yields.

Furthermore, the domestic middle-class within many emerging markets continues to grow in terms of both size and wealth, bringing with it a new source of potential demand. As this group increases its income, it is likely that there will be a higher propensity to save and invest, and some of that income will be directed towards government bonds.

Some investors might suggest that the amount that global investors hold in emerging markets government bonds is relatively low given the attractive yields available. With alluring yields and lower risks of governments defaulting on interest payments, emerging market local currency bonds might represent an attractive investment opportunity.

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