Will emerging market bond funds continue to outperform?

Emerging market debt (EMD) refers to the bonds issued by governments and companies in developing countries, such as Brazil, China, India, and Russia. These bonds tend to come in one of two forms: those denominated in US dollars (sometimes called hard currency) and those denominated in the country's local currency.

"There are corporate and government bonds in the world worth about $100 trillion, and of that roughly $80 trillion is issued by companies and governments in rich countries and $20 trillion by those in poor countries," explains Jan Dehn, head of research at asset manager Ashmore. "In the past, investors would often buy EMD when there was a risk-on environment, [for example] when US stocks went up and economies were recovering. But 2010-15 produced the exact opposite. Emerging markets were really on the back foot and fell five years in a row against the US dollar as investors have been selling them."

The main reason for the lack of investor interest in EMD over the past half decade, he argues, was the impact of quantitative easing (QE) which saw huge bond buying programmes by central banks in developed markets such as the US, UK, European Union and Japan.

"Emerging markets ended up being sold in order for people to chase the fixed-income bubble in developed markets, but now QE has run out of steam and most governments are considering rotating back to fiscal policy," he says. "Four other factors that led to a lot of selling in emerging markets - the strong dollar, the fall in commodity prices, the taper tantrum [in 2013] and the US Federal Reserve rate hike - had remarkably little effect on fundamentals, but have had a huge effect on prices. A situation when the fundamentals don't deteriorate a lot but the prices go down a lot is called value, and that's exactly what we have in the EMD market right now."

Another reason why Mr Dehn believes EMD is currently attractive is the level of income on offer and the difference between the rate emerging markets are growing compared with developed markets.

"The World Bank is predicting a steady pick-up in the growth premium between emerging markets and developed markets, with a gradual slowdown in developed markets over the next three years," he says. "Better growth means better fundamentals and therefore investors incur less risk, but in addition there's a very strong positive correlation with emerging market currencies and the emerging market growth premium. This suggests we should get some currency appreciation as well as the high bond yields."

Analysts at asset manager Source also highlight areas of potential value opportunities in emerging market debt. "Brazilian 10-year yields are above 11 per cent or 5 per cent on US dollar debt; Turkish 10-year yields are above 11 per cent or close to 6 per cent on US dollar debt, and Venezuela, which is a basket case but offers 10-year US dollar yields above 22 per cent is well below the 2016 peak of 36 per cent but still above the pre-2015 norm of 10-15 per cent."

Darius McDermott, managing director at research company FundCalibre, believes the cheapness of the EMD asset class alongside the high yields on offer is attractive.

"The EMD debt areas do yield substantially more than developed markets," he says. "For example you've got funds like Aberdeen Emerging Markets Bond (GB00B5L9HN22) yielding close to 7 per cent. In a world hungry for income you can find it in this asset class - why I would consider having it as part of a portfolio."

Mr McDermott also points out that many emerging market economies are less indebted than some western countries. For instance, Paraguay has public debt equivalent to 9.5 per cent of its gross domestic product (GDP), Russia has 12.6 per cent and Turkey has 29 per cent. By comparison, the UK's level of public debt to GDP stands at 89 per cent, while the US is at 108 per cent, according to the IMF World Economic Outlook for 2016.

Gary Potter, co-head of the F&C multi-manager team at BMO Global Asset Management, is also positive on emerging market debt. He says the high yields the asset class offers are particularly useful when building inflation protection into your portfolio.

"I think you are being well paid to take the risk but you've got to accept volatility," he says. "Our firm recently did some research into which has been the best asset class to be in between 1996 and 2016, and by a wide margin it was emerging market debt. The return was something like 660 per cent over 20 years, compared to MSCI World Index which returned produced 250 per cent over the same period."

Emerging market debt headwinds

As well as the usual risks you can expect when investing in emerging markets, such as higher volatility, typically lower corporate governance and less stable politics, there are several risks specific to EMD.

Adrian Lowcock, investment director at Architas, says: "Emerging market debt can be attractive as an asset class, but it is quite complex and ultimately a higher-risk area within the bond universe."

He adds that it is higher risk than developed market high-yield bonds and arguably more complicated. A key factor is the relationship between emerging market currencies and the US dollar. If the dollar strengthens compared with local currencies it can negatively affect the ability of emerging market borrowers - both countries and companies - to repay their debt.

"A few years ago when the dollar was strong there were concerns about some countries credit-worthiness - the so-called fragile five: Turkey, Brazil, India, South Africa, Indonesia - because as the US dollar got stronger their debt burden got higher," explains Mr Lowcock. "Although it helps to have a stronger US dollar, you don't want it too strong as that can have an impact on corporate profitability. A strong dollar increases the value of the debt and the servicing of that debt, because [borrowers] have to buy more dollars to service the debt.

"Likewise you want a weaker local currency to ensure that local, domestic companies are more profitable, and can keep their businesses operating and export their goods and services. You don't want a slide in their currencies because that could undermine confidence, but you also don't want them too strong because that undermines corporate profitability and companies' ability to repay their debt. So it's a not too hot, not too cold Goldilocks kind of scenario."

The interplay of macro-economic factors across individual emerging markets and the wider global economy, particularly the US, leaves it unclear whether the emerging market debt rally will continue.

Rob Morgan, investment analyst at Charles Stanley Direct, says: "Emerging markets are caught in the middle of two conflicting trends. On the one hand dollar strength is a headwind as it makes dollar-denominated debt servicing more expensive, but the positive impact of a strengthening US economy on world growth is beneficial. Add to the mix the impact of uncertain US trade policy and we may see something of a mixed year for emerging markets despite structural growth domestically. China will remain a key economy to watch as world growth is increasingly reliant on its health."

One of the biggest threats facing EMD is what policies US president Donald Trump will be able to implement. He has promised to force Mexico to build and pay for a wall between its border with the United States, terminate the North American Free Trade Agreement and hit China with high trade tariffs.

"The big red flag is President Trump," says Mr McDermott. "While the rhetoric is very strong from him there are still lots of questions, so what he will be able to deliver is as yet unclear."

Claudia Calich, manager of M&G Emerging Markets Bond Fund (GB00B4TL2D89), says one potentially large risk is how the Chinese economy and currency will be affected by President Trump's actions.

"The big elephant in the room is the Chinese yuan renminbi which continues to be vulnerable to capital outflows and potentially negative news, should the new US administration pursue unfriendly trade policies and or name China a currency manipulator," she says.

Due to the risks involved, Mr Lowcock suggests investors have a maximum of 1 to 2 per cent of their assets in emerging market debt, arguing this should be part of your existing high-yield exposure rather than replacing it.

Funds to consider

Mr Lowcock prefers hard currency debt funds as he thinks they are lower risk than those focused on bonds denominated in their domestic currencies. He also thinks the US dollar will remain strong for the time being.

He suggests BlackRock GF Emerging Markets Bond (LU0297941386). "The manager of this fund, Sergio Trigo, takes a different approach to many of his peers and believes that themes and scenarios will influence the EMD sector rather than inflation and growth," says Mr Lowcock. "This allows him to take a shorter-term view of the market and have a plan B if things do not work out."

Mr McDermott doesn't mind whether a fund invests in US denominated debt or local currency debt.

"There is more volatility with local currency but skilled fund managers can use their macro views to try and find currencies that are undervalued and have greater returns," he says. "Broadly, I would like a fund that offers a mixture and lets its manager use his expertise to determine where is best on a relative basis."

His favourite fund in this space is Standard Life Investments Emerging Market Debt Fund (GB00B8J3Q414). He says: "It's not as high yielding as some funds but has good long-term performance. Its managers take a macro view first by going for the countries they believe are stronger. When I last spoke with the manager in September, he was negative on Turkey, underweight South Africa and positive on Indonesia due to a new president."

Mr McDermott says Aberdeen Emerging Markets Bond is good for investors who need higher income. This fund pays out a monthly dividend and has an ongoing charge of 1.16 per cent.

Charles Stanley Direct includes Investec Emerging Markets Blended Debt (GB00B7PWB404) in its Foundation Fundlist of favoured funds. This aims to achieve long-term total returns primarily through investment in public sector, sovereign and corporate bonds issued by emerging market borrowers in both US dollars and local currencies.

"We regard the Investec emerging market debt team as one of the most stable, well resourced and experienced teams in the peer group, though they have historically struggled to beat the benchmark," comment analysts at Charles Stanley Direct. "They have taken some steps to try to correct this, such as larger conviction position sizes and fewer holdings and performance has improved as a result. We believe they are a team to watch in this specialist area."

If you want a fund focused on local currency debt, then Mr Lowcock suggests Pictet Emerging Market Local Currency Debt (LU0465232295).

"As the name suggest this invests in local currency debt so investors are getting access to currency exposure which can increase volatility and impact on returns," he explains. "The team analyses all opportunities on a bottom up as well as top down basis. This provides them with an advantage in an environment where prices are not necessarily rational and where avoiding pitfalls is more important than identifying good opportunities."

Fund performance

Source: Morningstar

Performance data as at 13 January 2017