Five Reasons to Be Positive About Emerging Markets Bonds | American Funds

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Five Positives on Emerging Markets Bonds

Key Takeaways

  • Lower yields in developed markets are boosting demand for emerging markets bonds.
  • Rate hikes by the Fed or China worries may cause setbacks, but many developing economies may have improved resilience.
  • Many bonds offer attractive risk-adjusted return potential. Currency tailwinds have picked up, as have economic growth and reforms prospects.

Gains in 2016 and 2017 have thrust emerging markets bonds back into the spotlight after years of uneven returns. The rally in emerging markets debt has some investors considering whether they should add or increase exposure to the asset class in their portfolios. Investors are also evaluating whether the turnaround in emerging markets bonds is sustainable. We believe the following are key reasons to be constructive:

  • Despite setbacks, governments are making gradual progress on reform efforts.
  • Commodity prices have stabilized, while currencies are appreciating.
  • Many economies and governments’ finances are relatively sound.
  • The flexibility of emerging markets to respond to macro shocks has improved.
  • High yields are attractive in a lower yield world.

 

Large Yield Advantages Remain, Despite the Emerging Markets Rally Emerging Markets and Select Developed-Country Bond Yields

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Sources: J.P. Morgan, RIMES, Thomson Reuters.
Through 6/30/17. Month-end yields for U.S. dollar–denominated bonds and local currency bonds are drawn from the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified and J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified, respectively.
The J.P. Morgan Emerging EMBI Global Diversified is a uniquely weighted emerging market debt benchmark that tracks total returns for U.S. dollar-denominated bonds issued by emerging market sovereign and quasi-sovereign entities.
The J.P. Morgan GBI-EM Global Diversified covers the universe of regularly traded, liquid fixed-rate, domestic currency emerging market government bonds to which international investors can gain exposure.
These indexes are unmanaged, and their results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.
This report, and any product, index or fund referred to herein, is not sponsored, endorsed or promoted in any way by J.P. Morgan or any of its affiliates who provide no warranties whatsoever, express or implied, and shall have no liability to any prospective investor, in connection with this report. J.P. Morgan disclaimer:

1. Despite Setbacks, Governments Are Making Gradual Progress on Reform Efforts

Politics can have a profound impact on bond markets. In the years following the Asian financial crisis in 1997 and the Russian debt default in 1998, political reforms helped spark economic and fiscal improvements and bond market gains.

While there are some exceptions like Turkey, where a crackdown by the government since the coup attempt in July 2016 has clouded the outlook for bonds and the economy, positive developments are once again underway in many countries.

The nature of the catalyst for structural reform varies. In some places where reform was absent, slowing global growth has pressured commodities and currencies, prompting a change of political leadership. Promising reform efforts are underway in India. Prime Minister Narendra Modi has made some progress on economic reforms since he was elected in May 2014. In August 2016, Parliament approved a goods and services tax — a key legislative victory for Modi’s party.


2. Commodity Prices Have Stabilized, While Currencies Are Appreciating

Chinese demand for many commodities has grown much more slowly, and in some cases declined, in recent years. To varying degrees, the economies and currencies of commodity-exporting nations have borne the brunt of this change. Meanwhile, low oil prices have provided an economic lift to net importers like India.

So far in 2017, many emerging markets currencies have held steady or moved higher, while commodity prices have mostly stabilized. Economic challenges remain, but some developing economies that rely on commodity exports seem to have turned a corner.

Brazil and Russia, two of the larger bond markets, are poised to continue their recovery from recession next year. Currencies of both countries — the real and the ruble, respectively — have appreciated substantially against the dollar.

The surprise decision by OPEC in September 2016 to cut production, followed by the extension of these cuts in early 2017, should eventually support higher oil prices over the long term. Demand for industrial commodities remains stable as government spending on infrastructure projects in China picks up. Authorities there are opening the coffers in a bid to smooth the economy’s passage toward slower (but more sustainable) growth. Recent data points to a spurt of commodity-intensive industrial activity. The improvement among developed economies is also typically encouraging for emerging economies’ currencies and markets as demand for industrial commodities increases.

Major Energy Exporters’ Growth Is Expected to Pick Up in 2018 Economic Growth Forecasts (%)

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Growth forecasts are full-year projections from the World Economic Outlook database
Source: International Monetary Fund.

3. Many Economies and Governments’ Finances Are Relatively Sound

Modestly improving global growth has sparked greater optimism. In many emerging markets, growth rates continue to far outstrip their developed-country counterparts. High inflation remains a challenge for only some developing economies — and even in those, authorities are mostly focused on reducing it.

Current accounts (the difference between imports and the sum of exports and net foreign income) are broadly supportive. Thanks to surpluses in Asia and Europe, and modest deficits elsewhere, many currencies appear less vulnerable to big drops.

Although a number of countries in Africa and Latin America face serious fiscal challenges, government balance sheets are in decent shape in numerous other developing economies. Debt-to-GDP ratios, a measure of a country’s indebtedness, are lower than they have been. And where debt loads are heavier, it’s often a sign of maturing bond markets.


4. Greater Flexibility to Respond to Macro Shocks

A couple of big question marks hover over emerging markets: How will they cope if there’s a major global growth shock from China or Europe? Could a lurch higher in U.S. Treasury yields derail the emerging markets turnaround?

Both concerns are valid and cannot be ignored. Developments along these lines certainly could create near-term volatility. That said, there’s good reason to believe that many developing economies are now better able to navigate market stress.

Currency is a very important aspect of improved resilience. Foreign exchange reserves are generally substantial. Crucially, most exchange rates float freely rather than being pegged (tied to the dollar or another standard). Floating exchange rates enable economies to adjust to external pressures. Current account deficits widen before tending to reverse course as economies rebalance. Weaker currencies often go hand in hand with reduced demand for foreign goods while making exports more competitive in international markets, for example.

Central banks can play a critical role in steering an economy through choppy waters. Many central banks have greater independence than they once did, and also have the resources to support growth (and bond prices) with more accommodative monetary policies if needed. This is especially important now as developed market central banks begin to move away from more accommodative monetary policies.
 

Diverse Conditions Make a Case for Selective Bond Investing Potential Economic Strengths and Weaknesses in Select Emerging Markets

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Inflation, currency and financial health assessments based on 2018 consensus forecast; latter two measures based on current accounts and budgets relative to gross domestic product.
Larger deficits may create potential for economic vulnerability. Growth forecasts from IMF World Economic Outlook database.
Sources: Capital Group, Bloomberg Finance L.P., International Monetary Fund, Thomson Reuters.

5. The Attractiveness of High Yields in a Lower Yield World

Many investors are seeking yield at a time when it’s relatively scarce. U.S. bond yields are close to their lowest ever levels. In Japan and Europe, negative policy interest rates have sent many bond yields below zero.

The substantial yield advantage of emerging markets bonds should persist. It’s likely that central banks in developed economies will need to keep rates lower for longer as global growth prospects remain muted.

Against this backdrop, a typical emerging markets bond yield of about 5% is hard to ignore. That said, higher yielding sovereign issues, such as Venezuelan dollar bonds and Nigerian local bonds, can reflect underlying credit issues or fundamental imbalances and warrant close monitoring. It’s important to be selective.

Active investors are able to focus on finding those bonds whose potential returns appear to offer adequate compensation for the risks entailed.

For investors seeking to benefit from these five constructive themes, the opportunity set is broad. The investable universe of emerging markets bonds totals around $6 trillion. It includes a variety of local currency and dollar-denominated issues offering a wide range of yields.

Arguably, local currency bonds are particularly appealing amid signs that the dollar’s five-year bull market may be in its final stages. Despite appreciating in recent years, some currencies remain close to historically low valuations against the dollar. Currency could, therefore, have more of a neutral impact on total returns over the next year or so.
 

It’s Not All About Success Stories — Challenges Also Create Opportunity Outlook and Bond Yields for Select Emerging Markets

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Representative yields as of July 31, 2017.
Sources: Capital Group, J.P. Morgan.


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