Emerging Market Bond Funds for Your Portfolio

Risks surrounding currency, inflation and US policy are leading fixed income fund managers to find opportunities in local currency emerging market bonds

David Brenchley 6 November, 2017 | 9:12AM
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Local currency emerging market debt is becoming an attractive investment opportunity

Risks around emerging market countries are subsiding - creating opportunities in emerging market debt, says Claudia Calich of M&G Investments.

For years now, emerging markets have been at the whim of both commodity prices and US monetary policy, as well as, for the past year, president Donald Trump’s political agenda.

However, prospects for many EM nations are now looking up, says the manager of the M&G Emerging Markets Bond fund.

For starters, none of the populist policies Trump put forward on the campaign trail – slapping huge tariffs on certain countries’ imports, mass deportation of Latin American workers and branding China a currency manipulator – have yet come to fruition.

“Maybe the good thing that is happening is that the administration is so disjointed that not much is happening, for good or for bad,” Calich says. “Yes, it’s a missed opportunity for the US but in terms of emerging markets it hasn’t been as bad as feared.”

Elsewhere, fundamentals are beginning to assert themselves and currencies continue to stabilise after strong depreciations from 2013 to 2015. As a result, Calich says she is “finding more investment opportunities in the local currency space”.

While many emerging market governments will issue dollar-denominated debt, some issue theirs in their local currency, posing an extra risk, foreign exchange risk, for investors. A strong US dollar, therefore, would be negative for returns when translated.

Year-to-date the US dollar index, which measures the greenback against a basket of currencies, has declined almost 8%. While two or three interest rate rise seem forthcoming from the Fed, Calich says these have been priced in so emerging markets can deal with them.

Colin Dryburgh, investment manager with Kames Capital’s multi-asset team, agrees on the currency question. “Despite performing well year-to-date, many emerging market currencies do still appear to be attractively valued relative to history, while the US dollar is currently expensive,” he explains.

Kames makes the point that the real yield – the 10-year government bond yield less current headline inflation – on the average emerging market bond is around 3%, while for developed markets it’s in negative territory.

“This combination of attractive currency valuations for many regions, coupled with high real interest rates relative to developed markets, makes local currency EMD an attractive asset class for multi-asset funds,” Dryburgh adds.

Another aspect that has helped propel a recovery in local currency bonds is the global disinflationary trend, in which emerging markets are also participating. Calich picks out Brazil as the most stark example of this, with inflation decreasing from 11% to 2.5% in the space of a year.

Funds to Up Your Emerging Market Exposure

The Kames Diversified Growth fund holds the Morningstar Bronze rated iShares JPMorgan EM Local Government Debt ETF (SEML) as a top holding.

The SPDR Barclays Emerging Markets Local Bond UCITS ETF (EMDL) is rated Silver by Morningstar analysts. The ETF tracks the tracks the Barclays Capital Emerging Markets Local Currency Liquid Government Index, which includes local currency bonds issued by emerging market countries with the most liquid markets.

Jose Garcia-Zarate makes the point that, while many would advocate an active approach to the asset class, this ETF has consistently outperformed its peers. “This is an asset class fraught with difficulties and it seems that finding an active manager who will deliver consistently is not an easy task.”

If you do prefer to go down the active route, both the GAM Multibond Local Emerging Bond and Pictet Emerging Local Currency Debt are Bronze rated by Morningstar analyst Shannon Kirwin.

For more general exposure to emerging market bonds, the Bronze rated Templeton Emerging Markets Bond fund has the ability to invest in local currency issuance.

While emerging markets are fast-growing and yields in the area tend to be higher than in developed markets, this is for a reason - default risk is higher in emerging markets, as witnessed in Venezuela this week. Therefore, these niche funds and ETFs should only account for a small part of your investment portfolio.

Venezuela president Nicolas Maduro said state oil company PDVSA would make one more $1.1 billion (£840 million) debt payment on a bond due in 2017 but have to restructure its remaining obligations of around $89 billion. Failure to do so would result in the country defaulting on payments.

Calich says that "the announcement raises more questions than answers", with little clarity on whether they seek to restructure both sovereign bonds and PDVSA bonds or only one of them. US sanctions placed it its chief negotiator also complicates matters.

The exact timing og the default is hard to predict, Calich says; though analysts at Bank of America Merrill Lynch predict it will come in the second half of 2018.

"The announcement should not produce contagion into other EM assets," adds Calich.

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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David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk