Investors Poised to Boost Emerging-Markets Debt, Despite Jitters

Emerging-markets bond funds may seem a contrarian play, but investors still crave their potential for high yields.

General Economy As Turkish Lira Weakens 5th Day Against Dollar

Mixed denomination Turkish lira banknotes sit in this arranged photograph in Istanbul, Turkey, on Sunday, Jan. 5, 2014. The Turkish lira is poised to rebound after a corruption scandal engulfing Prime Minister Recep Tayyip Erdogan’s government pushed the currency to its most oversold level in a decade. Photographer: Kerem Uzel/Bloomberg

Kerem Uzel/Bloomberg

Many emerging markets got off to a turbulent start in 2014, with local currency volatility and political risk common threads. These concerns were on the back of trepidation late last spring over the Federal Reserve’s tapering of its quantitative easing program. Even so, some market observers say that institutional investors may be ready to increase their allocations to bond funds that invest in emerging-markets debt (see also “Recent Stock Market Volatility May Be a Taste of What’s to Come”).

According to Karin Anderson, senior mutual fund analyst at Morningstar in Chicago, such funds remain attractive on a fundamental level because they offer investors high yields and currency diversification. Furthermore, she says, many of the emerging markets issuing government bonds have low debt levels, giving them a comparative advantage against developed nations with heavy debt loads.

There is another long-term trend that favors emerging nations. Institutional investors are “looking to increase” the share of their funds they invest in emerging-markets bonds because their allocations have not kept up with the growth of this market, according to Michael Gomez, co-head of the global emerging-markets portfolio management team at Pacific Investment Management Co. (Pimco) in Newport Beach, California. In spite of what Gomez calls “cyclical gyrations” roiling these markets, “major institutions in the U.S., Europe and sovereign wealth funds and many of our clients across Asia and the Middle East are certainly thinking about increasing allocations to the asset class, and we see some of that coming through.”

Will institutional investors surge into emerging bonds this year? After all, in the fourth quarter of 2013, there was a $12.8 billion net outflow of money from these funds, which held $385 billion in assets under management at year-end 2013, according to eVestment, a data research company based in Marietta, Georgia. “I think for some, the volatility has caused them to increase the pace of their search activity and, in certain cases, increase the size of their allocations,” says Gomez. “Other people, I think, have decided to hold off and wait out the volatility. So I wouldn’t say it is a clear trend either way.”

Anderson identifies four types of emerging-markets funds and investment strategies that have evolved since the 1990s: dollar-denominated emerging-markets sovereigns, local-currency-denominated emerging-markets sovereigns, emerging-markets corporates and hybrid emerging-markets funds that combine investments from the first three strategies.

On the surface, it would seem counterintuitive that investors would want to boost their allocations to emerging-markets bonds during a period of volatility. This class of investments could face further jitters with potentially higher U.S. Treasury rates sparked by the Fed’s ongoing tapering of bond purchases. Says Anderson: “Managers that owned Indian rupees or had exposure to the Turkish lira, even just a little bit, saw those currencies fall about 30 percent or so last year,” pushing down overall fund performance. “That’s something for investors to keep in mind, not only in the emerging-markets space but also in the world bond space in a fund with a lot of emerging-markets exposure,” she says.

Yet institutional investors’ online search activity in recent months shows a rising interest in emerging-markets bonds, according to eVestment. The company is forecasting that institutional investors will allocate a net new $50 billion to emerging-markets bond funds this year. The projection is based on eVestment’s modeling of recent search patterns within its database, performance analytics and key macroeconomic measures, according to Rich Donnellan, eVestment product manager.

Jitters in emerging markets have taken a toll on bond values. During 2013 the J.P. Morgan emerging-markets index (global) a dollar-denominated sovereign debt index, fell 6.58 percent, with much of that happening in May and June. Year-to-date as of January 31, the index had declined by an additional 1.02 percent. As of February 18 the index has leveled off, with a year-to-date growth rate of 0.02 percent, more than compensating for its slight January decline. The sell-off has been steeper for bond funds denominated in local currencies. The J.P. Morgan government bond index for emerging markets (global diversified unhedged) sank by 8.98 percent in 2013. Year-to-date through January 31, this index had declined an additional 4.63 percent. Year-to-date as of February 18, the index is down 1.61 percent, nearly erasing its January slide.

Pimco has seen its own share of outflows. The dollar-denominated Pimco Emerging-Markets Bond Fund – Institutional (PEBIX) was hit with a $5.37 billion, or 14 percent, net outflow in the fourth quarter of 2013, leaving its assets under management at $32.6 billion at year’s end, according to eVestment. Pimco sustained a sharper $1.08 billion, or 43 percent, net outflow for its Pimco Emerging Local Bond Fund – Institutional (PEBLX), which invests in local currency sovereigns, leaving the fund with $1.4 billion in total assets under management at year’s end. Morningstar rates both Pimco funds gold.

Despite their recent mixed showings, both Pimco funds have outperformed over the long term. According to eVestment numbers, PEBIX surpassed its benchmark in 2013: –5.68 percent, compared with –6.58 percent for the benchmark, J.P. Morgan emerging-markets bond index (global). Year-to-date, the fund is down by only 0.05 percent as of February 18. Over the past five years, the fund has bettered its benchmark, averaging 12.25 percent annually against the benchmark’s 11.52 percent.

PEBLX underperformed its J.P. Morgan government bond index for emerging markets benchmark in 2013, declining by 10.06 percent compared with a decline of 8.98 percent of its benchmark, according to eVestment. The fund lost 4.64 percent in January, but as of February 18, its year-to-date return had improved to –1.65 percent. Overall during the past five years, this fund has beaten the benchmark, with an average annual return of 9.69 percent, compared with 8.06 percent for the benchmark.

Investors have also taken to emerging-markets corporate bond funds. A couple that Anderson recommends are the Stone Harbor Emerging Markets Corporate Debt Fund (SHCDX), which is up 1.13 percent year-to-date as of February 18. Another is T. Rowe Price’s Emerging Markets Corporate Bond Fund (PACEX), up 1.02 percent year-to-date as of February 18. Both have bounced back from January declines.

The newest investment class, flexible total return funds, gives investors a way to obtain active management across the broad spectrum of emerging-markets bonds, according to Anderson. Within this category, Anderson particularly likes the Fidelity New Income Markets Fund (FNMIX), which Morningstar rates silver. John Carlson, the manager of the fund, won Morningstar’s fixed-income manager of the year in 2011. This fund is down 0.18 percent year-to-date on February 18.