Emerging Market Bond Funds: Outlook Improves for 2016

An increasing number of emerging markets' central banks are independent of their governments - good news for bond investors in the region

Morningstar Manager Analysts 13 January, 2016 | 10:47AM
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Emerging markets debt markets struggled to perform in 2015 due to a number of idiosyncratic and macroeconomic factors. Performance has been hit the hardest in areas more sensitive to economic growth in emerging markets, such as local currency bonds.

Returns for hard currency government bonds, as represented by the JPMorgan EMBI Global Diversified index, have not been great either. Although they are in positive territory year-to-date, they’ve been helped by the strong rally in risk assets seen in October.

Among the main macro considerations, it is evident that the “managed” economic growth slowdown in China has been the key event challenging the stability of emerging market economies. The slowdown in China – in light of the realignment of its economy to a consumption-driven model – was seen to be particularly harmful to commodity-exporting countries, such as Brazil.

In this environment, commodity-importing economies in emerging markets were lined up to be net beneficiaries of the resulting sharp drop in commodity prices; however, this expectation has not materialised.

Emerging Market Currencies Struggle

Compounding the existing headwinds, the expectation of an interest rate hike in the US, driven by a stronger labour market and economic growth data has seen the US dollar strengthen and emerging market currencies weaken considerably. Putting things in perspective, the Brazilian real has depreciated by almost 40% against the US dollar since the beginning of the year; similarly, the Turkish lira – expected to benefit from lower oil prices – has depreciated by almost 20%, though in Turkey’s case, idiosyncratic factors have also contributed, e.g. political instability as a result of inconclusive elections and conflict in the country’s southeast.

Despite it becoming more evident which countries are in a fundamentally strong position, differentiation has not rewarded investors as expected. For example, Mexico is a common holding among most investors, an expected beneficiary of accelerating US economic growth and is considered a high quality issuer relative to other emerging markets, but also when compared to some Developed Market issuers.

Despite its improving fundamentals and solid trajectory, it has seen its currency depreciate by almost 17% against the US dollar and its hard currency sovereign bond spreads widen over the past year. This is not due to deterioration of the fundamental story but more due to its currency’s highly liquid nature, which makes it a casualty of short positioning when panic arises in emerging markets and investors need to hedge their exposure using liquid means of implementation.

Fund Flows Disappoint

In terms of fund flows into emerging market debt funds, the third quarter of 2015 was unforgiving for all three sub asset classes; hard currency, local currency and corporate debt. The summer months saw significant outflows across the board from both institutional and retail investors, according to Morningstar data. However, it hasn’t been so bleak for blended and hard currency-biased funds, where fund flow activity has been net positive, mainly driven by institutional demand and since the beginning of 2014.

In spite of the recent difficult environment for emerging markets, investors should acknowledge that emerging market economies have matured, which is a reason for being less pessimistic. There has been a marked improvement in the way emerging market countries’ governments formulate policy and in the increasing number of central banks that are independent of their governments.

Also, exchange rates for half of emerging market countries are free-floating, a number that has doubled over the last 20 years. Lastly, the challenging environment for commodities is expected to create more dispersion within the emerging market complex, which should generate opportunities for active investors willing to take a long term view and withstand the expected inherent volatility.

More Choice for Investors

From an investor’s standpoint, the asset class is becoming more diversified with regards to both the opportunity set and investment approaches. Furthermore, investors can access a variety of return drivers for portfolio construction. For instance, hard currency debt will provide investors with exposure to emerging market sovereign and corporate credit spreads relative to US treasury yields, but no non-US dollar currency risk; whereas local currency debt is an asset class almost entirely driven by each individual emerging market country’s local yield curve and currency exchange rate dynamics.

In reference to local emerging markets’ currency debt, it was rare to find many dedicated strategies fifteen years ago. Today, it’s just one of the many choices offered to investors. In addition, a number of different strategies/approaches have launched over the past few years to give managers more flexibility in accessing the asset class, e.g. ‘Blended Emerging Market Debt’ strategies which can be benchmarked against a mix of the JPMorgan EMBI Global Diversified index and JPMorgan GBI-Emerging Market Global Diversified index.

A further variation from this approach is those strategies that not only can access the broad opportunity set offered by hard currency debt and local currency debt, but can also use derivatives to both enhance returns and manage risk exposures; these strategies can also increase cash balances to dampen volatility during periods of market stress and to seize the opportunities that such environments create – i.e. more attractive valuations.

Flexible strategies feature among the strongest performing over the past couple of years, as managers have used their discretion to prioritise capital preservation either by increasing their cash balances or implementing hedges through the use of financial derivatives.

This article was written by Carlos Gonzalez-Lucar, CFA, CAIA, Manager Research Analyst for Morningstar for International Adviser Magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar Manager Analysts

Morningstar Manager Analysts  research and rate hundreds of OEICs, unit trusts and investment trusts available for sale in the UK.