“Emerging market bonds should be part of the investment mainstream, but as yet they are not,” Mark Baker, investment director, emerging market debt at ASI told a media briefing in Hong Kong on Monday.
“We expect the growth differential between emerging market and developed markets to widen in 2020, driven by economic recovery in a handful of the larger emerging economies. This dynamic is typically a bullish signal for emerging market assets, especially currencies,” he said.
Baker co-manages the $1.53bn Aberdeen Standard Sicav I Select Emerging Markets Bond Fund, which is authorised for sale to retail investors in Hong Kong and Singapore.
It has a 14.64% three-year cumulative return, outperforming the sector average (13.18%), but lagging its benchmark JPM EMBI Global Diversified (USD) index (19.76%).
Top holdings indicate strong bets away from the index (which is dominated by large Latin American borrowers such as Brazil and Mexico), and include US dollar bonds issued by Qatar, Saudi Arabia, the Bahamas, El Salvador, Dominican Republic and Ukraine, according to the fund’s factsheet.
The fund’s annualised volatility of 4.83% is higher than both the index (4.17%) and its sector average (4.44%).
“We expect the pursuit of yield to result in healthy flows to emerging market bonds,” said Baker.
The JPM EMBI GD index returned 15% last year, outperforming other fixed income categories, including US high yield, emerging market local currency, emerging market US dollar corporate and global investment grade bonds, according to ASI research.
Strong demand for US dollar-denominated assets is likely to persist in a low policy rate environment, likely resulting in greater spread compression for emerging market high yield sovereign and corporate credit bonds relative to high grade ones, Baker argued.
Several investment strategists have also become more positive about emerging market bonds during the past few weeks in expectations of a successful phase one trade deal between China and the US.
For instance, Ben Powell, chief investment strategist for Asia-Pacific at the Blackrock Investment Institute, told a media briefing shortly before Christmas that he was overweight high yielding US dollar-denominated Latin America bonds and Asia local currency debt, including China and Indonesia.
“Valuations for US dollar-denominated bonds still look attractive compared with developed market assets and investors remain structurally underweight the asset class,” Baker said.
He likes Brazil, Russia and Turkey because of their strong economic growth prospects, but is especially keen on China property bonds despite their strong rally last year, although he prefers double-B rated issues of large market leaders with diversified real estate portfolios.
“It is a crowded sector, and some of the small property companies with fragile balance sheets are vulnerable to default,” he noted.
“We also see idiosyncratic investment opportunities in domestic frontier markets such as Ukraine and Egypt, where authorities have embarked on significant macroeconomic reforms that are reducing inflation,” he added.
Indeed, last October, ASI gained approval from the Monetary Authority of Singapore to sell its Frontier Markets Bond Fund in the city-state. The $534m fund, which Baker helps manage, contains names on the high-risk end of the credit spectrum, such as Iraq, Egypt, El Salvador, Benin and Ghana, according to the fund’s fact sheet.
In the same month, ASI launched a fashionable fixed maturity product in Singapore, but one that focused on US dollar-denominated emerging market bonds to lock in extra yield for four years.
Domestic debt opportunities and risk
However, Baker’s greatest enthusiasm seemed to be for local currency emerging market bonds.
He pointed out that in general, emerging market currencies remain undervalued in historic terms, with a widening differential since 2016 between the GDP weighted real effective exchange rate of 17 emerging market currencies and the returns of the JPM GBI-EM GD (FX) index.
“There is scope for incremental policy rate cuts in a number of emerging market economies, including Brazil, Mexico, India, Indonesia and the Philippines,” he said.
Baker sees especially attractive opportunities in China and India.
“Continued interest rate reform will provide a supportive background for duration [that is long-dated bonds] in China, and 3.5% yield on 10-year China government bonds compares very well with sovereign credits, such as South Korea, compared to which investors can generate twice the return,” he said.
In India, reform momentum might have stalled, but the country should continue to reap the benefits of previous measures that are lowering core inflation, he argued.
However, he warned India assets are vulnerable to a higher oil price prompted by an escalation of the Middle East crisis and to government fiscal slippage if economic growth were to fall further.
In fact, “the major headwinds in all emerging markets for investors to be mindful of include further dollar strength, the continuation of US exceptionalism, a deeper Chinese growth slowdown and an escalation in trade tensions,” said Baker.
“But, these are now risks that investors need to accept as normal,” he added.
Aberdeen Standard Sicav I Select Emerging Market Markets Bond Fund vs benchmark and sector average