As the global economy starts to recover from the Covid pandemic, the T Rowe Price multi-asset team believes emerging market local currency bonds can play an important role in portfolios as an income-generating growth asset.
While bond yields have been rising, Yoram Lustig, head of Emea multi-asset solutions at T Rowe Price, says EM local debt still offers much higher yields than developed market government bonds.
To prove this point, at the end of January, the JP Morgan GBI-EM Global Diversified Composite Index yielded 4.3% compared with yields of 0.42%, -0.74% and -0.03% for the five-year US Treasuries, German bunds and UK gilts respectively.
“In other words, the spread between EM local bonds and Treasuries was 3.9%,” says Lustig. “While this is not a particularly large spread historically speaking, in a low yield world, an extra 3.9% – nearly 10 times the five-year US Treasury yield – is an attractive uptick for income-seeking investors.”
Exposure to US yield curve
According to Lustig, emerging market financial assets are set to benefit from three tailwinds. First, the estimated medium-term economic growth rate is higher than those of developed market countries, second, their populations are younger, and third, higher yields today may decline over the next decade as they continue to mature.
“Although EM US dollar‐denominated bonds may benefit from receding risk premiums as the credit quality of emerging markets should improve, their exposure to the US yield curve means they will not benefit as much from falling EM rates as EM local bonds would,” Lustig says.
“EM local debt, on the other hand, is priced off the yield curves of EM countries, meaning that investors in the asset class may benefit not only from coupon income – or high yields – but also from potential capital gains because of falling rates in EM countries.”
Also boosting the appeal of EM local debt, adds Lustig, is that performance has historically been positive correlated with emerging market currencies and negatively correlated to the dollar.
He says: “EM local debt effectively involves investing in two asset classes – EM sovereign bonds and EM currencies – and it is the cheap valuation of EM currencies, not necessarily the valuations of EM bonds as reflected in their spreads, that may boost the total return of EM local bonds over the next decade.”
Currency vs local bonds
While positive on the prospects for the asset class, Lustig adds that, given it is a risk asset, investors should only consider holding it as part of a well-diversified portfolio.
He says, however, that because the correlation of EM local bonds with other traditional asset classes has been imperfect, adding just a modest amount of the asset to a portfolio may actually – and perhaps counterintuitively – reduce risk within portfolios focused on growth assets in particular.
“In markets where many assets have stretched valuations, tight spreads, and low yields, investors should consider EM local debt as a potential source of income and growth in their portfolios,” he says.
For Justin Onuekwusi, head of retail multi-asset funds at LGIM, while the case for holding EMD is attractive, his preference is to hold it via hard currency bonds rather than local bonds.
“The case for holding EMD has been buoyed by the commodity price rises that we have seen, with a faster recovery taking place in those Asian emerging markets and less so in Latin America and Eastern Europe,” he says.
“We like hard currency bonds because, relative to corporate bonds, the valuation gap is quite large,” Onuekwusi adds. “At the same time, as emerging market spread is remaining elevated versus high yield and corporate bonds, the fundamentals also look quite attractive, going from the famous fragile five down to the troublesome two in Brazil and South Africa – maybe three if you include Turkey.”
But on the flip side, he says the recent increase we have seen in bond yields traditionally tends to negatively hit high yielding bonds more so than developed market bonds.
“The Federal Reserve’s bond buying programme has been wound down by congress which means that the backstop for corporate bonds, and crossover names in high yield, has effectively disappeared,” he adds.
“In terms of local currency, two thirds of the volatility and risk is in local EMD, which for me means the valuation case for holding them is less so as it is for hard currency EMD versus other dollar-denominated corporate bonds.”
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