Pension funds and other institutional investors that are increasingly searching for ways to add stable yield to their portfolios find themselves grappling with how to best tap into the yield potential of emerging markets debt. With the U.S. dollar declining from historic valuations, there is a growing consensus that now may be an opportune time to be exposed to emerging markets debt.
Favorable emerging markets sentiment
Central banks from Brazil and Colombia to India, Indonesia, and Russia have lowered interest rates, providing a backdrop of economic stimulus. Even with these lowered rates, current sovereign yields found within most emerging markets are higher than their developed markets counterparts. The ending U.S. dollar cycle provides an additional boon to investors, decreasing currency volatility.
Hemant Baijal, Co-Head of OFI Global’s Global Debt Team, believes the evidence of the dollar’s impedance on economic growth surfaced a couple of years ago. “By 2015, the dollar’s strength was starting to have a negative impact on U.S. economic growth. In a world where leverage isn’t being increased, it has become clear that the U.S. can’t absorb this level of U.S. dollar strength without the economy slowing down,” he says.
Adding further fuel to strengthening emerging markets economies is a broad recovery in the commodities markets, where a broad index of global prices has risen more than 40 percent since early 2016.
“We see the recovery in commodities as an important factor driving emerging markets credit,” says Chris Kelly, Co-Head of OFI Global’s Global Debt Team. “Even though commodity prices have softened a bit, they’ve remained at a fairly buoyant level. With China’s slowdown being managed well, as it appears to be, and with a weaker U.S. dollar, we expect commodity prices to remain in this range.”
What if the Federal Reserve raises interest rates?
Relative to the taper tantrum of 2013, when investors overreacted to the mere threat of interest rate hikes by the Fed, global bond markets appear much stronger and more sanguine. “A critical difference today is that real interest rates are significantly higher,” says Wim Vandenhoeck, Co-Portfolio Manager of OFI Global’s Emerging Markets Local Bond Strategy. “In 2013, during the taper tantrum, real rates in emerging markets were around 1 to 1.5 percent; now they’re at 3 to 3.5 percent, providing a much larger cushion.”
With stronger balance sheets and more room for central banks to manage monetary policy, emerging markets countries are currently better equipped to deal with any potential fallout from U.S. interest rate hikes.
Opportunities in local currency
Local currency issues offer valuations that should appeal to any potential investors eyeing emerging markets debt.
“The local currency market responds to underlying country fundamentals, such as monetary and fiscal policy. In contrast, hard currency bonds respond more to credit dynamics,” says Baijal. “At this stage, we think local currency bonds offer better investment opportunities. We don’t always invest by deciding between a country’s local currency or hard currency. Instead, we allocate our risk budget by investing where we can potentially get the best returns for the risk we’re taking.”
OFI Global believes decisions on overall currency exposures should be considered separately, and can be rendered independent of a specific country’s bond exposure through hedging or by investing explicitly to either gain or reduce exposure to a given currency.
“Overall, we do think the current environment is favorable for local currency bonds,” Baijal adds. “And active management of currency is an integral part of global fixed-income portfolio management because it allows you to extract additional value and take advantage of additional diversification.”
“Rather than make decisions on an aggregate level, we examine the opportunities country by country and assess relative risk and reward in each environment,” Kelly says. “In Brazil, for instance, we can underweight the sovereign bond based on valuation, preferring a state-owned oil company bond based on a number of company-specific drivers that have improved its credit over the past year. Also in Brazil, we like some pulp and paper companies that have lower levels of risk. They’re primarily exporters and actually benefit from Brazil’s political volatility, which causes the real to weaken, which then makes them more profitable.”
Learn how we challenge expectations with our Emerging Markets Local Bond Strategy.
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Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future, will cause a portfolio's investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at or near historic lows. When interest rates rise, bond prices generally fall, and the value of the portfolio can fall. Below-investment-grade (“high yield” or "junk") bonds are more at risk of default and are subject to liquidity risk. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile.
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