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Juice still left in emerging market bond rally

But the surge in emerging market bond prices this year is forcing investors to be more discriminating.

In the hunt for yield, fixed income investors have been encouraged by stimulative monetary and fiscal policies in Asia, while yields on developed market bonds remain at record low levels.

“There’s been strong overseas demand for Asia ex-Japan bonds all year, supported by substantial regional buying,” Robert Stewart, head of global fixed income strategies at JP Morgan told FSA.

The JP Morgan Asia Credit Index (JACI), comprising government and corporate US dollar issues from eight Asian countries and Hong Kong, has returned 8.5% this year to 22 September, according to the firm.

“We now prefer corporate to sovereign credits, though recommend rotating from out-performing high yield (11%) to investment grade (7.9%) credits,” he said.

Augusto King, head of capital markets group in Asia at MUFG, agreed that investment grade offers better value than high yield in regional credit. He also has “a defensive preference for sectors that are more driven by consumers than by industrial growth,” such as infrastructure and telecoms.

However, Stewart pointed out that Asian corporate bonds (earning 5.25%) are dear compared to US high yield (earning 6.9%) — although the average credit rating in the JACI is one notch higher at B+.

In addition, he believes that “Asian bonds are likely to be steady but relatively unexciting performers. There is more bang for your buck in [hard currency] Latin America sovereign credits such as Brazil and Argentina and corporate names in Brazil and Mexico, as well as attractive carry by owning East European [for example Poland and Hungary] domestic bonds.”

Both Stewart and King are comfortable with duration in this benign interest rate environment.

“Given our expectation of a measured and limited pace of hikes by the Fed in the next couple of years, we have been relatively comfortable with duration. We would rather extend duration than go down to lower quality credits to enhance returns at this point,” King said.

Carry appeal in local currencies

Stewart recommends adding local currency risk as interest rates remain stable among G4 central banks, at least until the US presidential election and the Fed rate decision in December.

Indonesia 10-year notes pay an attractive 6.8% and with inflation at a seven-year low of 2.8% there is scope for further interest rate cuts by Bank Indonesia. But, Stewart warns that “it is a well-populated position, so it is vulnerable to risk events”.

Long duration bonds in India earn a similar yield, inflation is also falling and the central bank is likely to stay dovish on interest rates so overseas investors can continue to enjoy a positive carry.

At the higher end of credit ratings, among Asian domestic markets, Stewart likes Malaysian bonds paying out around 3.5%.

“Investor flows should continue into Asia local currency bond markets due to positive carry against a background of stable G4 interest rates – barring a risk event that prompts a switch to safer haven assets,” he said.


EM credit indices have been robsust so far this year


 JP Morgan indices  YTD return   Currency
 Asia Credit Index   8.5%  Gov/corp USD issues
 EMBI Global Diversified   14%  USD-denominated
 GBI-EM Global Diversified   16%  Local currency EM bonds

Source: JP Morgan/Bloomberg. Data to 22 September 2016


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