The Zhitong Finance App learned that as the sell-off in the global credit market deepens, investors in emerging markets are cutting their riskiest bond positions. From Aegon USA Investment Management to JPMorgan Asset Management, many asset management institutions worry that soaring global interest rates may end the strong performance of emerging market debt.
Despite recent market turmoil, US Treasury yields rose to a nearly 20-year high, emerging market dollar bonds have recorded 1.4% returns over the past year. However, even as oil prices are above $100 per barrel and investors prepare for “higher and longer” global interest rates, credit spreads have narrowed to their tightest level since 2007. This unsettles fund managers, who think these bonds are bound to be sold off.
“When government interest rates rise, I'm a little worried about what this means for spread levels,” said Jeff Grills, head of emerging markets debt at Aegon. “When I'm looking for a major opportunity, it's hard to find.” He recently cut his exposure to Colombia while increasing his debt holdings from higher-rated borrowers such as Indonesia, Saudi Arabia, and the Philippines.
He's not the only one doing this. Neuberger Berman's Gorky Urquieta reduced positions in high-yield bonds in Ecuador, the Dominican Republic, and Zambia, making it difficult to find ways to increase risk to the portfolio. “We've always been in some contraction pattern,” Urquieta said.
This round of retreat comes after emerging markets have endured drastic repricing of global interest rates and conflict in the Middle East. Sticky inflation and a resilient US economy drove US bond yields to soar as traders bet on the Federal Reserve's more aggressive path of austerity. However, emerging market dollar bonds have maintained their gains so far. According to J.P. Morgan Chase data, the interest rate spread between US dollar debt and US debt in developing countries is only 170 basis points, the narrowest since 2007.
This relative strength is one reason investors are uneasy. Valuations are still too high, and US bond yields have risen sharply, which means that emerging market credit bonds have less room to absorb another round of global interest rate shocks when interest spreads do not widen drastically. According to industry research, the Federal Reserve policy was the main risk for hard currency emerging market debt in the fourth quarter, and said that interest spreads close to a 19-year low may amplify the impact on national bonds.
Cautious sentiment is also beginning to be reflected in money flows. The world's largest ETF that tracks emerging market hard currency bonds last week experienced one of the biggest single-day outflows since March.
Some investors chose to improve credit quality rather than completely abandon emerging market debt. PPM America's Matt Graves increased tenure through higher-rated borrowers such as Morocco while cutting riskier positions such as Angola, which had strong performance earlier this year. Others believe that the sell-off in US bonds is creating opportunities in suppressed investment-grade bonds. Fernando Grisales, senior portfolio manager at Schroders in New York, increased his holdings in Saudi Aramco and Mexican dollar bonds. “The long-term yield curve for investment-grade credit bonds is showing value. These bonds are very stable,” he said.
JPMorgan Asset Management takes a different route. Pierre-Yves Bareau, its head of emerging market debt, made his portfolio less sensitive to credit sell-offs and turned some of his risk to local-currency bonds, including Mexico, because he believed the swap market was overpricing interest rates. Local currency debt has continued to rise by an average of 0.9% this year, while indicators for developing country stocks have risen by more than 23%, outperforming developed market stocks. Higher local interest rates and higher commodity prices have also made markets such as Brazil and Colombia attractive to investors.
“Our risk is slightly lower,” Bareau said. “We operate on the other side more through local markets rather than credit bonds.”