Emerging-markets fixed income: A constructive view for the discriminating eye

Following a challenging year, 2014 has started off with continued volatility. Some clients are asking their advisers about risks in emerging markets while others are wondering if the turmoil presents a buying opportunity.
Encouragingly, the strong economic fundamentals that have driven emerging markets debt over several years remain largely intact, technical dynamics are supportive, and valuations have improved. Developed economies are gaining traction, removing a head wind in place for several years.
Significant risks remain, however, and country differentiation and asset allocation will be a key theme this year. Recent volatility in the asset class stems from two broad types of risk: those specific to the countries themselves, and those presented by a less predictable U.S. interest rate environment. Also, uneasiness persists regarding China’s economic re-balancing.
NOT ALL EMs ARE PAINTED WITH THE SAME BRUSH

Brazil and South Africa’s diminished growth prospects, and anti-government protests in Turkey, Ukraine and Thailand are high-profile examples of sovereign risk that have damaged sentiment recently. These stories are balanced by countries such as Mexico, Colombia and the Philippines that are reaping the rewards of market-friendly reforms. Several Eastern European countries are benefiting from an ongoing recovery in the European Union, while Sub-Saharan Africa offers investors a fresh selection of rapidly expanding economies.
The sudden increase in U.S. Treasury yields beginning in May 2013 left investors anxious about the transition away from years of exceedingly easy monetary policy. Though interest rates appear set to climb, the speed and magnitude will be muddled by conflicting signals about the U.S. and global economic recovery. Importantly, subdued inflation is allowing major central banks to commit to a low-rate environment through 2014.
The ramifications of reduced global liquidity have been borne by emerging-markets currencies; several have depreciated 5%-20% versus the U.S. dollar over the past year. In the process, markets have tested local-currency bonds in countries like Brazil, Indonesia, and Turkey as investors and central banks struggle to calibrate interest rate differentials between developed and developing countries. Encouragingly, floating exchange rate regimes in emerging markets are playing their designed role of acting as economic shock absorbers and preventing more damaging dislocations.

Diversified opportunities in emerging-markets fixed income ensure that not all assets have or will perform similarly. Within local markets, Hungary, Romania and Nigeria delivered positive returns on an unhedged basis last year. In U.S. dollar bonds, many high-yield sovereigns posted gains, moderating the losses in interest rate sensitive investment-grade securities. Emerging-markets corporates have been more resilient on the whole, given their shorter duration profile.
AN ATTRACTIVE ENTRY POINT
The yield backup across assets is providing an improved entry point for investors. The spread on U.S. dollar sovereigns, close to 350 basis points over U.S. Treasuries, is above the 10-year average. Emerging-markets corporate bonds offer significant spread premiums over similarly rated U.S. corporates, and emerging markets’ domestic-interest-rate differentials are at five-year highs versus U.S. Treasuries.
Valuations are enhanced given that economic fundamentals in emerging markets have improved and remain largely superior to developed countries. Though expanding slower than recent years, emerging economies maintain their growth edge, and they run more balanced budgets. Public indebtedness in emerging markets has fallen from 50% to 35% of gross domestic product over 10 years, while developed countries have levered up significantly. The improved credit quality of the asset class, at 66% investment-grade — versus just 35% a decade ago — is a testament to this progress.
Fund inflows, a positive technical force over several years, showed vulnerability beginning in May 2013 as retail investors reduced exposure. However, institutional investors represent approximately 80% of the investor base in emerging-markets debt. Data shows that pension, insurance, and sovereign wealth funds have steadily increased their allocations, often using corrections as a buying opportunity.
The maturation of emerging markets now allows investors to better manage the various country-specific sources of risk. Opportunities for diversification — both of countries and assets — are greater than ever. There are 61 index-eligible emerging-markets countries today, almost double 10 years ago. Emerging countries’ domestic-currency-debt markets have grown rapidly and are multiples larger than traditional hard currency markets, providing access to distinct monetary policy cycles.
Economic development has also facilitated access to global debt markets by the private sector. Corporate issuance in U.S. dollars has been robust in recent years, and predominantly high-grade. Foreign-exchange risk is often mitigated by prudent hedging strategies or deriving revenues in major currencies. Emerging-markets corporates offer investors further differentiation opportunities, providing exposure to nuanced trends in retail, energy, banking, industrials, or telecommunications.
STAYING ALERT IN 2014
The coming year will present its own set of challenges. In addition to U.S. interest rate volatility, emerging markets face a heavy electoral calendar in 2014. Prominent countries such as Brazil, Turkey, India, Indonesia, and South Africa will go to the polls. While election outcomes serve as an important barometer of reform momentum, the institutional capacity of these countries has reached a stage where shifting political tides will not portend radical policy changes.
Finally, economic prospects for the U.S. are improving, while the eurozone is emerging from recession. If these trends take hold, they can spur a cyclical revival in emerging economies to complement their positive long-term structural dynamics. Despite the various head winds, emerging markets are poised to maintain their attraction for fixed-income investors over shorter and longer time horizons. Advisers with clients who can look through periods of volatility should be rewarded.
Ehsan Iraniparast is an emerging-markets analyst at Payden & Rygel