Emerging Markets Bonds Can Be a Haven. Where to Play.
Are emerging market bonds a haven or a risk asset? A bit of both, to judge by the recent global market turmoil.
Some 60% of the asset class is composed of sovereign debt from investment-grade countries, from Poland to Saudi Arabia and South Korea, notes Edward Al-Hussainy, senior currency analyst at Columbia Threadneedle Investments.
Yields on those bonds fell as stocks around the world hit an air pocket in early August. But spreads over U.S. Treasuries, investors’ go-to benchmark, widened by about 20 basis points to 130 basis points, says Jeff Grills, head of emerging markets debt at Aegon Asset Management. (A basis point is 1/100th of a percentage point.)
That looks modest. High-yield emerging market paper widened more, sucking the oxygen out of the year’s hottest trades on turnaround stories like Argentina, Turkey, and Ecuador.
“The lower the credit rating, the bigger the selloff has been,” says Valentina Chen, co-head of emerging market debt at fixed-income specialist MacKay Shields.
Local-currency debt is treading water. But managers worry about the fading of the so-called yen carry trade: borrowing cheaply in Japan to reinvest in high-yielding Latin American markets. As the yen surged 9% over the past month against the dollar, the Mexican peso slid 6% and Brazilian real 3%.
With equities continuing to gyrate, the prevailing mood on emerging market bonds is wait and see. “Activity is muted and bid/ask spreads very wide,” Chen says.
Once some dust settles, though, pickings could be rich at the stronger end of the asset class, says Cem Karacadag, head of emerging markets sovereign debt at Barings. “I liked spreads last week,” he says. “I love them today.”
Emerging markets writ large have been fiscally responsible since the pandemic, while advanced economies gorged on debt. That makes repayment problems unlikely for investment-grade issuers, he argues.
“It would take another Covid shock or global financial crisis to move the needle on fundamentals,” Karacadag argues.
Chen is looking farther afield to corporate credits. One focus is Turkey, where a range of solid corporate borrowers are undervalued because their credit rating cannot exceed the government’s, which is well into junk territory at B+.
She also likes state-owned enterprises in the Middle East, whose credit is backed by oil gushers. Saudi Aramco, the regional giant, issued $6 billion in new debt last month.
Dip-buying looks premature to Al-Hussainy, with the prospect of a U.S. recession back on the table. Federal Reserve rate cuts will help emerging markets if they ease a “soft landing.”
They will hurt if they are a sign that the biggest economy is shrinking. “You’re making a bet on why U.S. rates are coming down,” he says. “Right now, it’s not clear.”
Then there is the small matter of a U.S. presidential election just three months from now. Donald Trump’s return to the White House, particularly with a Republican Congress, would pose multiple threats to emerging markets, Al-Hussainy says—from his proposed 10% tariff on all U.S. imports to tax cuts that could reignite inflation and put rate cuts on hold.
Samy Muaddi, portfolio manager for emerging market bonds at T. Rowe Price, is a bear on valuation. The iShares J.P. Morgan USD Emerging Markets Bond exchange-traded fund has climbed 15% from a trough in October 2022. Few bargains are left at these levels.
“We’re a few days into a correction after almost a two-year rebound,” he says.
Equity investors might think the same, or not.