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Amid hopes that the Federal Reserve is nearing the end of its interest rate tightening cycle, bonds bounced back in January with Bloomberg US Aggregate Bond Index gaining 3.33%.
For income-hungry clients that have higher levels of risk tolerance, advisors may want to consider revisiting select corners of the bond market in search of great upside. Those include emerging markets debt. A battered asset class in 2022, emerging markets are bouncing back to start 2023 as highlighted by a January gain of 3.44% by the widely observed J.P. Morgan EMBI Global Core Index.
Neither dollar-denominated emerging markets bonds nor the local currency equivalents were spared last year. A strong greenback pinches dollar-denominated debt issued by developing world governments by boosting external financing costs. When emerging markets currencies sag, as was the case last year, companies benefit if their revenue is earned in foreign currency, but there is no such respite for local currency debt.
While the Fed’s plans remains to be seen, those scenarios could reverse in 2023, potentially paving the way for emerging markets debt upside.
EM Bond Setup Looks Good
Advisors and clients alike are likely chastened by the dour performance of the broader bond market in 2022, but there’s no denying there are currently multiple factors favoring emerging markets debt.
“The investment case for emerging markets (EM) debt is pretty compelling. First, in a world rightly concerned about excessive debt and insufficient yields, EM has an answer: EM governments are subject to debt constraints and pay market-determined yields,” according to VanEck research. “Second, we believe EM debt has ‘worked’ for over a decade – we note that backward-looking efficient frontiers tell investors to have far more EM debt versus a current, average allocation of an institutional investor. Third, market structure in EM debt is characterized by liquidity, default rates and recovery values that are in line with many developed market (DM) bond markets.”
Adding to the case for EM sovereign debt is that central banks in developing economies, broadly speaking, were proactive in raising rates to damp inflation while the Fed was not. As such, EM central banks concluded their tightening cycles than DM counterparts and that could give the former latitude to potentially pare borrowing costs this year.
Additionally, a variety of crucial fundamental metrics favor EM debt over DM government bonds and those extend beyond higher yields.
“Government debt-to-GDP example, shows that DM debt is not just higher than the global mean, but higher by 2 standard deviations, while EM is in line with the global mean,” adds VanEck. “The same is true for a range of other metrics, such as fiscal deficits, current account deficits, etc. Our point is that on a wide range of fundamental metrics (not just debt levels, however important they are), EM is in line—if not arguably superior—to DM.”
On a related note, EM bonds offer more potential for credit upgrades relative to already highly rated DM equivalents.
EM Bond Fundamentals Compelling
Of course there are exceptions, but a broad view of EM vs. DM bonds indicates clients can access comparable fundamentals with the former will gaining superior compensation. That’s a good trade-off.
But there’s more to the story and it’s also good news. Advisors may want to consider evaluating the net creditor status of developing economies. Hint: It’s encouraging when compared to developed markets and that’s a plus for EM debt.
“Net creditor status measures, essentially, how much a government owes in dollars, relative to their resources in dollars. EM is filled with net external creditors, meaning countries that have more dollar assets than dollar liabilities. In other words, they could literally buy back their entire debt stock,” concludes VanEck.