The actions of the US Federal Reserve, once a headwind for emerging market (EM) bonds, could now finally be turning into a tailwind, according to some asset managers.
When the Fed embarked on its interest rate hiking cycle, the performance of emerging market bonds was dampened by a strengthening US dollar and rising financing costs faced by EM borrowers.
But as the Fed is set to pivot to interest rate cuts, some asset managers argue that emerging market bonds and currencies could be starting to become attractively positioned as the headwinds reverse.
“If you believe, as we do, that the US Federal Reserve is now at terminal rates, then US Treasury yields could actually be a supportive tailwind for the asset class in 2024,” said Janus Henderson’s Emerging Markets Debt Hard Currency Team in a recent report.
The team also argued that the market technicals for EM bonds could be better than many expect: “Perhaps too much focus is put on the record outflows seen over the last two years,” they said.
“The flip side is this has left a cleaner starting point in terms of investor positioning, and higher all-in yields in fixed income which should support demand from EM dedicated investors.”
“A bigger decline in yields next year may see market access returning for some high yield countries, which creates a positive feedback loop.”
The team added that after adjusting for the distressed sovereign borrowers in the CCC rating and lower segment of borrowers, sovereign credit spreads overall are actually pricing-in a soft landing.
“Our universe continues to see elevated spread dispersion and desynchronisation across countries, creating opportunities for active investors,” they added.
Valuations look attractive
Although rate cuts by the Fed are certainly a positive factor for EM bonds, Michele Barlow, Apac head of investment strategy at State Street Global Advisors, told FSA that spread widening in the asset class puts it in a relatively good position.
“If you look at high yield and investment grade in the US, where spreads are now at super tight levels, spreads have become wider in emerging markets over the last year – so on a relative basis, they look attractive.”
Although much of the widening spreads in emerging market debt come on the back of certain high yield issuers facing difficulties over the past year, Barlow said that most of the investment grade sovereigns are still in reasonably good shape.
“If we have that soft landing, which is our base case scenario, emerging markets debt should do reasonably well,” she said.
Beware of a significant global slowdown
However Barlow noted that the asset class could face some headwinds if global growth slows significantly.
“A lot of these are exporting oriented countries so that’s going to weigh on them, but I think from a financial position they’re in pretty good shape.”
GAM Investment Director Paul McNamara also thinks the outlook for policy rates is a positive for the asset class.
“Looking at yields, and the biggest driver – inflation and policy rates – gives us grounds for optimism,” he said. “Looking across the EM world we continue to see plenty of value.”
“Several EM countries are showing forward-looking real yields much higher than longer-term averages, even allowing for further disinflation.”
He said absent a recession in 2024, or a significant slowdown in global economic growth, higher yielding EM hard currency bonds should deliver strong returns with the “weakest part of the credit stack” performing the best.
