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Merian turns risk on to EM bonds

US interest rates on hold, a stabilised dollar and more synchronised global growth rates support emerging market debt prices, argues Merian fixed income director Huw Davies.

The tide has turned in favour of  risk assets, Davies told FSA during a recent visit to Hong Kong.

“We are now in a new environment, with central banks in the US, Europe and China looking to ease monetary policy to boost economic growth. In particular, the rapid shift in the Federal Reserve’s interest rate stance in the wake of the plunge in asset prices in the final quarter of last year shows that it will respond to market signals,” he said.

In particular, emerging market bonds – both hard and local currency – should benefit from a confluence of benign factors.

Dollar-denominated emerging market bonds should post strong returns after a disappointing performance in 2018, with the JP Morgan GBI EM Global Composite Index falling 5.98%.

Emerging market bonds “tend to perform better when global economic growth is synchronised”, according to Davies. During the past two years, a surging US economy has attracted investment inflows to its financial markets and effectively crowded out other asset classes.

Meanwhile, the strength of the dollar early last year as a result of President Trump’s fiscal stimulus package devastated returns on emerging market domestic bonds, with FX losses wiping out positive interest rate carry. A flat, or even weaker, dollar this year now make high yielding markets compelling, especially where inflation is subdued.

Davies likes Brazil, Mexico, the Philippines and Indonesia.

“Real yields of 5% to 5.5% in Indonesia are especially attractive,” said Davies, and a flat-to-weaker dollar reduces the anxiety about the country’s high level of dollar-denominated corporate debt.

On the flip side, accommodative central bank monetary policies raises the spectre of inflation, so Merian’s strategic absolute return bond fund, managed by Mark Nash and Nick Wall, is taking a long position in inflation-linked bonds. It is also underweight high yield credit, partially as a hedge for its risk-on positions.

Perhaps, the fund’s most idiosyncratic bet is a long position in European bank contingent convertible bonds – so-called CoCo bonds. These are fixed income securities that turn into equities at a pre-specified trigger event to shore up a bank’s tier-one capital, and were designed as post-crisis remedy to systemic risk and an alternative to taxpayer bailouts.

“Solid names such as HSBC, Santander and Lloyds offer yields of around 8%, yet they have the 4-to-5% volatility of short-dated bonds because they trade to their [early] call-date, rather than on expectations of a conversion trigger event,” said Davies.

Merian Strategic Absolute Return Bond Fund vs absolute return sector average

Source: FE Analytics. Three-year cumulative performance in US dollars.

The fund aims for “stable levels of volatility uncorrelated to bond and equity market conditions”. Below is one year performance of the fund versus equity indices.

Source: FE. In US dollars


Part of the Mark Allen Group.