Emerging markets bonds have notched big gains in 2016, despite political turmoil and economic setbacks. Though it is difficult to definitively say that the market has turned for the better, portfolio manager Rob Neithart says there are good reasons for investors to feel positive. The yield advantage of emerging markets over developed markets is hard to ignore, and in some cases valuations are as attractive as they’ve been in years. He also talks about:
- Positive signs in Argentina; continuing caution on Brazil
- The ongoing attractiveness of India, despite its strong gains
- His view on the U.S. dollar
Does the rally in emerging markets bonds mean that the poor return environment of recent years is behind us?
So far, market returns in 2016 have been strong. It’s difficult to say whether we’re turning a corner. Overall, the past five years has been a challenging environment for returns — especially compared to some other high-grade fixed-income markets. The silver lining of that unfavorable run is, of course, that many bonds offer relatively high yields.
It is hard to pin down an inflection point and we don’t try and time markets that way. Emerging markets will remain volatile, and that is an important consideration when thinking about the size of an exposure. That said, there are many parts of the market offering substantial yields, and potentially attractive entry points for longer term investors. One to three years from now, it’s likely we’ll look back at this period and find that it was a good time to be invested.
As you look back at the challenging period of the last few years, how would you characterize them?
Declines in bond prices (which move inversely to yields) over recent years were largely justified. Economic activity has weakened in many countries, and there is recession in Russia and Brazil — two of the larger bond markets. Some economies have pursued unsustainable policies.
Now we are starting to see a change in attitude among many policymakers. The pain of staying with the status quo has begun to exceed the pain of changing for the better. We can see the beginnings of an adjustment process — not everywhere, but in enough parts of the market. This development, combined with historically weak returns and higher risk premiums, makes me feel like there is more of a glass-half-full outlook.
But it’s not uniform across all markets. There is still a significant premium attached to doing credit work and trying to pick the winners among sovereign and corporate bonds across the entire emerging markets universe. Investors must differentiate to find those select bonds that offer an attractive balance between valuations and fundamentals. Interestingly, the combination of relatively high yields and reform prospects that we’re seeing in some emerging markets can be a sweet spot for bond investors.
Where are the most compelling investment opportunities currently?
There are some attractive pockets of opportunity for longer term investors — Argentine dollar bonds, a handful of relatively small credits that issue dollar debt in Africa, and Indian local currency bonds, for instance. So it is important to have the flexibility to invest in different currencies and securities to be able to tap into the entire opportunity set in these markets. There’s no particular part of the emerging markets bond universe that is unambiguously attractive right now. Given weak global growth and uncertainty around China’s economic outlook, the mixed environment for emerging markets could be with us for a while.
Amid weak growth, some developed economies have adopted negative interest rates. What’s the impact on emerging markets debt?
In a strange way, those negative interest rates cast emerging markets fixed income in a more favorable light, because there is little yield to be captured in the higher quality markets without taking credit risks, and in some cases a lot of credit risk. Emerging markets have their challenges and there’s a need to do deep credit work, but overall, I think they have better debt sustainability characteristics, healthier balance sheets, fewer imbalances, and better growth prospects. And you still get very generous yields.
Argentina returned to capital markets in April after a 15-year break. The $16.5 billion bond issue was the largest ever emerging markets offering. Why are investors so excited?
It’s simple: there’s now hope for a brighter future. Argentina reached the kind of tipping point I described earlier. The economic hardships and political dysfunction were so severe that they prompted the electorate to vote for new leadership.
No government is perfect, but I believe President Mauricio Macri’s administration is pursuing a better policy mix. They scrapped most currency controls and the Argentine peso now has a more reasonable valuation. They also seem to have a better handle on managing public finances. Regaining access to bond markets for the first time since the default in 2001 was a crucial step forward for Argentina. Renewed access to international bond markets breaks a significant logjam in its public finances and creates greater opportunity for Argentina to grow.
Could Brazil — whose bonds have rebounded in the past six months — follow Argentina’s playbook, and what’s your view on Brazilian bonds?
First, I should emphasize that it’s still early days in Argentina. Given that country’s fundamentals, I think its bonds offer great return potential — but only if the new government makes the meaningful reforms that are widely hoped for.
In Brazil, efforts to impeach Dilma Rousseff (who was suspended from her role as president) have increased the chances of a leadership change. That, in turn, has set the scene for those very high Brazilian yields to decline. Unfortunately, Brazil has a long road to travel and it must overcome recession, high inflation and poor management of public finances.
Brazil operates a northern European–style welfare state at a middle- to lower income GDP per capita income level. So the sustainability of the spending is doubtful and that makes bondholders nervous. They need to implement structural reforms that are easy to articulate, but very difficult to get done politically. I’m not convinced that Brazilian currency and bond valuations currently offer adequate compensation for the risks entailed. The real still seems vulnerable and bonds have rallied quite a lot already, so I’m not that excited about their return potential.
India is a prime example of political change and reform sparking a bond market rally. Is there still value there?
India still interests me from both a valuation and portfolio construction perspective. I’m focused on local currency investments because there’s little dollar debt and it’s expensive.
Since Prime Minister Narendra Modi was elected in May 2014 there’s been more of a reformist attitude. It’s been recognized that deregulation and greater access for foreign investors can enhance growth. Authorities are also taking the task of reducing inflation very seriously. That all adds up to a favorable environment for capital inflows, which should in turn help support the currency.
It also lays the groundwork for a structural decline in inflation, which may exert downward pressure further out along the yield curve. Bonds of long maturity could be a great investment over time. Another thing I like about the local currency bonds is their idiosyncratic risk-return characteristics. Indian bonds tend to march to the beat of their own drum and can, therefore, serve as a source of portfolio diversification.
The U.S. dollar’s bull run, which began in 2011, seems to be relenting. Is the dollar cycle turning?
It’s a hugely important question. For several years there were sound arguments in favor of a strengthening dollar. The supply of dollars into the global financial system, Federal Reserve policy and the relative strength of the U.S. economy all pointed in one direction. Today, the overall picture for the dollar appears much more ambiguous. Even so, I think the dollar may begin to climb once more. Given current valuations, however, any further gains are likely to be relatively limited.