- Eurozone bond yields pose challenges for fixed income investors
- EM bonds offer an attractive alternative to Eurozone debt
- Many smaller EM issuers offer compelling opportunities
Following ECB action that has pushed bond yields to record lows, European investors are facing a challenge in how to target returns that come close to their liabilities. As a result, many bond markets outside of the EU that offer higher and steeper yield curves are proving tempting. One example is emerging market (EM) bonds. According to JP Morgan indices, the yield pickup from US dollar-denominated EM sovereign bonds over EMU sovereign bonds is as high as it was in 2009. Meanwhile, the yield premium on EM local currency bonds compared to EMU sovereigns is the highest on record.
These potentially higher returns do not come without risk, however. Successful investing in EM bonds in recent years has required substantial care and attention. Emerging markets usually prosper en masse when global trade is growing and liquidity abounds. However, trade growth has been stagnant for half a decade and although the world remains awash with liquidity, there are well justified fears that this will soon begin to drain away. Indeed, low-demand growth has lasted so long that emerging markets have been through years of counter-cyclical policies designed to soften the impact on their economies until the recovery came. However, the global recovery remains elusive, and many emerging economies are slowing again as the stimulus wears off and the costs of stimulus begin to weigh. Despite this, many opportunities remain.
At Standard Life Investments, we find that many of the larger sovereign issuers in emerging markets do not have compelling investment cases. Where there are interesting returns to be had, they are often not available across the whole range of instruments available. For example, macroeconomic trends in Brazil are exceptionally weak, and are not likely to improve in 2015. However, we believe that the market underestimates the growing political capital of the new finance minister and therefore overestimates both the probability of rating downgrades and the likely level of inflation in future years. This makes both domestic and dollar bonds attractive, although we are cautious on the value of the currency. In Turkey, we feel that after years of unchecked credit extension to the corporate sector, the nation’s balance sheet is vulnerable to an external shock. Furthermore, as independent institutions become increasingly politicised, the risk becomes more acute. Because of this, we prefer to limit our exposure to Turkey.
While major markets get headlines, many smaller emerging markets have positive economic trends that investors can seek to capitalise on. The Philippines has been growing above 5% per annum for several years, driven by investment in equipment and, more recently, by exports. Despite this, its global peso bonds are priced cheaper than South East Asian peers that are struggling with falling exports and weakening fiscal balances. In the Dominican Republic, a new multi-berth cruise ship terminal has powered the tourist industry to become the strongest per-capita in Latin America, while gold exports have also grown significantly. Although inflation ended 2014 below 2%, domestic bonds yield nearly 10% and 30-year dollar bonds also look attractive.
In this environment, managers must carefully balance valuations against fundamentals and be prepared to act decisively when the balance tips. Investors seeking higher yields should look for managers who will seek out the most sustainable returns while avoiding value traps.