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EM corporate bonds suffer worst H1 performance

Latest sell-off can be largely attributed to higher rates, stronger US dollar, rising oil prices, trade tensions.

Arlo Technologies signage displayed during the company's IPO at the New York Stock Exchange on Aug 3. Emerging markets climbed after US jobs data reinforced bets on gradual Federal Reserve hikes.

IT has been a difficult year so far for emerging markets (EM) corporate bonds, which as an asset class has suffered its worst first-half performance in recent history.

This latest sell-off can be largely attributed to the historically "terrible trio" of higher rates, stronger US dollar and rising oil prices - which tend to result in selling pressure on EM - in addition to considerable uncertainties resulting from the Sino-US trade war.

Investors in EM assets tend to suffer higher volatility - as a trade-off for higher long-term returns - and therefore periodic episodes of stress on EM bonds are not new. In fact, history shows the best periods to buy are often when prices decline to levels that reflect excessive pessimism relative to fundamentals.

After recent price declines, we believe that the risk-reward in EM corporate bonds is compelling again, and see the current combination of attractive valuations, healthy bottom-up fundamentals, and adequate economic growth outweighing the headwinds in the backdrop over the longer term.

While valuations are significantly cheaper versus their peaks in early February, corporate balance sheets have generally improved over the last few quarters with default rates still expected to be below historical averages.

Broadly, economic growth across global EM is also firm, and is expected to continue outpacing developed markets (DM) growth ahead.

This growth differential is reflected in the long-term performance of EM corporate bonds.

Since 2002, EM corporate bonds have led other fixed income asset classes in terms of risk-adjusted returns with a higher Sharpe ratio (defined by average annualised returns over annualised volatility) of about 1.2, versus 0.4 for US Treasuries and 0.6 for DM investment grade bonds.

One major reason for the latest weakness in EM corporate bonds was a rapid spike in rates in the first half of 2018, whereby the 10-year US Treasury yield jumped from 2.4 per cent to a high of 3.1 per cent in only five months, due to fears over rising inflation.

We expect this to be less of a headwind ahead, and see rates rising in a more orderly fashion from 2.9-3.0 per cent currently to 3.4 per cent over the next 12 months as markets reflect increased comfort with the trajectory of rates and inflation.

In an environment of rising rates, EM bonds can outperform. From December 2003 to December 2006, when the US Fed increased the fed funds rate from 1.25 per cent to 5.25 per cent, EM hard currency high-yield and investment-grade credits delivered 26 per cent and 13 per cent, respectively.

In addition, while a strong US dollar could remain as a headwind over the near to mid term, particularly as rising trade tensions weigh on the currencies of trade-focused EM economies, we highlight that current account positions across the EM universe have generally strengthened since the taper tantrum in 2013 and, at current levels, EM currency valuations are broadly in line with their fundamentals.

For investors seeking exposure to EM corporate bonds, we believe it is important to be widely diversified.

Because of the structure of the deep EM universe - comprising disparate countries in different geographic regions - and often significant idiosyncratic risks embedded in specific economies and corporates, a widely-diversified portfolio is critical in controlling downside risks, preserving capital, and achieving a meaningful risk-reward in line with the asset class as a whole.

In the arena of EM corporate bonds, we see significant scope for active management strategies to outperform passive strategies.

While DM countries have mature institutions and capital markets, the EM universe comprise different countries in a wide range of situations, ranging from economic and political crises to growth booms driven by structural fundamentals.

Alongside the higher yields offered, bond defaults are also more frequently seen in the EM bond universe. In contrast to passively replicating an index (which will allocate capital to the entire EM universe), active managers can sidestep the most unstable countries and also identify risks of corporate defaults, which can lead to long term out-performance.

Moreover, given that we are in a later stage of the economic cycle - with increasing tension between growth, inflation and rates - avoiding the "black holes" of the worst economies and corporate defaults could prove more important for investors.

Finally, there is far less transparency and discoverability of information in the large EM universe relative to DM. Given that EM markets are less efficient, there is greater scope for active managers to benefit from the efforts of fundamental analysts who can enhance discoverability and have a better understanding of conditions on the ground. This can result in long-term outperformance versus passive strategies.

  • Writer is head of Investment Strategy, Bank of Singapore

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