Emerging market bonds have sold off in the past two weeks since Federal Reserve Chairman Jerome Powell signaled a hawkish turn on U.S. interest rates.
But the average spread between emerging market hard-currency sovereigns and U.S. Treasuries remains near its post-pandemic low, around 3.4 percentage points, says Sergey Goncharov, head of fixed income for the Americas at Vontobel Asset Management. That’s down from 460 basis points five months ago – a strong recovery in fixed income terms. (A basis point is 1/100th of a percentage point.)
There are two ways to look at this stable performance: emerging market bonds remain fully valued and vulnerable to further global shocks, or emerging market economies are stable by historical standards, and an additional 340 basis points of yield are worth the risk. “The market is divided between spread sellers and yield buyers,” says Edward Al-Hussainy, senior currency analyst at Columbia Threadneedle Investments.
Industry professionals split the difference by turning to strong credits like those of Mexico, Indonesia and Saudi Arabia, to the detriment of higher-yielding securities. “We don’t look for risk in our portfolios,” says Samy Muaddi, portfolio manager for emerging market bonds at T. Rowe Price.
Expectations that the Fed would keep rates high for longer have undermined a driver of emerging market bonds: the anticipation of interest rate cuts in countries that have tightened interest rates more quickly and more aggressively than the United States in 2022-2023. These bets have focused on Brazil, Mexico and other Latin American rulers.
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“We separated from Latin American countries that cut rates after a massive rally in bonds,” said Michael Kelly, head of multi-asset strategy at PineBridge Investments.
Another driver has been political reform in countries that were in or threatened with credit default, from Argentina and Nigeria to Egypt and Turkey. This year’s unlikely fixed-income stars are Argentina and Ecuador, where new presidents promising fiscal austerity have returned bondholders as much as 80%, Goncharov says.
Further gains seem more difficult to achieve. “Nothing is cheap anymore,” he said. “High yield spreads have tightened from 1,000 to 600 basis points.”
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Emerging markets, with their immense diversity, remain fertile ground for bond pickers. Another macroeconomic scenario for 2024 – rising commodity prices – creates value in the debt of oil exporters like Colombia and Nigeria, says Eric Fine, head of emerging markets active debt at VanEck. Nigerian dollar bonds maturing in 2028 yield around 9% per annum. The three-year paper of Mexican state oil producer Pemex pays 9.5%.
PineBridge’s Kelly sees good deals in high-yield Asian corporate debt. The difficulties of Chinese real estate developers obscure the value elsewhere, he says. For example, Indian utilities, which are borrowing heavily to fuel the new, fast-growing economy.
“You get high double-digit returns on loans,” he says. Kelly also likes Macau casino debt in China, whose post-pandemic recovery is gathering pace.
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An example of national restructuring that could still make sense is that of Pakistan, adds Vontobel’s Goncharov. The International Monetary Fund approved a $1.1 billion tranche of aid for the country last month, citing “prudent policy management and the resumption of inflows.” Eurobonds maturing in 2027 yield north of 11%.
Clearly, these perceived bargains fall into the idiosyncratic category. The major problem with emerging markets is that they are no longer the main source of global financial risk. The IMF recently named four countries that “must take policy action to address imbalances”: the United States, China, the United Kingdom and Italy.
If these supertankers fail, no one will escape the waves.
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