After three years of supersized returns, a whiff—admittedly still faint—of caution appears in the air for emerging-market bonds. Still, the sheer diversity of this asset class and its solid long-term prospects lend it a resilience that investors are finding increasingly hard to overlook.
In the year to date (ended Aug. 25), total bond returns for emerging-market corporates logged gains of 8.22%, according to Merrill Lynch, after 8.79% and a sizzling 12.5% in the previous two years. An array of reasons may be cited in favor of emerging-market bonds: Emerging markets are a highly diversified asset class. Economic fundamentals are still favorable among emerging markets, characterized by healthy exports, sizable current account surpluses, and surging foreign-exchange reserves. Also, prudent fiscal management by governments has greatly improved the debt profile of many countries.
In addition, emerging-market corporates in some countries (notably Mexico in Latin America as well as Taiwan and Singapore in Asia) are replacing debt denominated in foreign currency with local-currency debt, which eliminates exchange-rate risks. Alternate strategies have also been followed to buy back higher-cost debt and replace it with cheaper debt. Such initiatives have reaped rich rewards for governments as well as corporate borrowers in the affected countries.
Issuance of longer-maturity bonds in recent years will provide incremental support for emerging-market corporate and sovereign borrowers because bond issuance with longer maturity has the effect of reducing near-term funding risk and lowering costs. Also, trends in commodity-futures prices indicate that healthy gains are likely to be logged in the coming months, with positive implications for emerging markets, which are among the principal beneficiaries of record prices in commodities such as copper, zinc, lead, nickel, aluminum, and gold.
Even with all those factors working in their favor, S&P believes a there are reasons for investors in these bonds to be increasingly cautious:
• After three years of a stupendous rally, emerging-market debt is now expensive, and additional gains beyond the mid-single-digit range will be challenging.
• Inflows of institutional funds into this asset class imply demand is still sizable at a time when supply is being constrained by debt withdrawals, buybacks, and so forth. A potential supply/demand imbalance could fan price pressures higher than fundamentals would warrant.
• The phenomenon of a synchronized upward trend in long-term interest rates in the euro zone, Japan, and the U.S. (among other countries) increases the risk of a flight to quality, with potentially negative consequences for emerging-market securities. A pickup in risk sensitivity would prompt investors to move up the quality ladder, increasing pressure on emerging-market issuers to raise spreads to more normal levels to compensate adequately for risk.
• Signs of slowing momentum in the U.S.—and, to a lesser extent, China—could compromise prospects for emerging-market exports, dulling one of the key locomotives of growth in recent years.
• Credit quality remains strong, as upgrades have topped downgrades for 13 consecutive quarters, but an examination of the outlook and CreditWatch distribution suggests that negative bias might have established a trough in the single digits for several quarters, signaling potential deterioration ahead.
• To date, the credit-market impact of political events has been relatively contained (notwithstanding pressure from diverse events including the Israel-Lebanon conflict, electoral uncertainty in Mexico, and terror attacks in India), but effects emerging from unanticipated geopolitical risks could turn the spigot away from emerging-market bonds.
Even though the yields relative to alternate fixed-income asset classes are still temptingly high enough to attract a sizable inflow of funds, a more cautious and nuanced approach to this asset class is warranted in the coming months.