Frontier bonds led the way, up 21% for the year. This was followed by EM local currency at 12.7%, EM hard currency at 10.4%, and EM corporates recording 9.1%.1 So, what's the catch?
In short, flows, or rather the lack thereof, into dedicated EM debt strategies. 2023 was the second consecutive year of net outflows (US$31.1 billion), although this was an improvement on the US$90 billion investors withdrew in 2022 (Chart 1). This activity was driven by the continued reduction in the size of balance sheets for central banks in developed markets (DMs). The growing negative relationship between US yields and EM bond flows also played a part. With a sense of déjà vu, we believe the US Federal Reserve (Fed) and the beginning of a cutting cycle will again be key catalysts for flows and returns in 2024.
Here, we look at what's in store for each sub-asset class in the coming year.
Chart 1. 2023 saw a continuation of outflows from EM debt. The drivers that shaped this are set to continue in 2024.
Source: JP Morgan, December 2023.
EM hard currency debt
In 2023, we saw tighter spreads but not lower yields. At an index level, 384 basis point (bps) spreads appear uninteresting.1 However, look beneath the surface and there is a stark divergence between investment grade and BB spreads on the one hand and the CCC-rated bucket on the other. EM sovereign investment grade looks tight on a historical basis and versus US investment grade, while the opposite is true for CCC names.
Following the US Federal Open Market Committee’s recent dovish signals, the funds rate median reading for next year is around 4–5%. That’s 50 bps lower than the September projection and 75 bps below the current setting. Fed funds futures now price a full interest rate cut by March. The question is what this dovish stance might mean for hard currency sovereigns. History suggests the period around the first cut of a cycle is not always positive for EM assets. That’s because cuts are associated with slowing growth and mounting risk aversion. Double-digit returns are not uncommon 6–12 months after the first-rate reduction, particularly for lower-rated high yield bonds.
EM countries' debt and fiscal outlooks will be equally important for returns. Interest rate costs are set to stay below nominal GDP growth, which should remain relatively high and wider versus DMs. It’s no secret that in recent years there’s been a deterioration in EM sovereign balance sheets. Countries can’t postpone their fiscal consolidation efforts indefinitely. However, interest rate/growth differentials provide breathing space for many countries to run a primary deficit while their debt levels fall.
A symbolic line in the sand?
Several countries trade with spreads above 1000 bps – a symbolic line in the sand for the market. Our base case is for no credit events in 2024, as those with notable maturities – Kenya, Pakistan, and Egypt – are willing and able to pay. Technical factors also support hard currency sovereigns, with investment-grade names dominating issuance. The lack of market access for lower-rated credits is a concern. However, we think default risk this year is lower than spreads suggest, with countries able to obtain cheaper official sector financing.
Yields for nations, such as El Salvador, Nigeria, and Kenya are above 10%, which makes market access difficult to justify. Local debt markets will have to take up some of the additional demand. At the same time, multilaterals like the International Monetary Fund will increasingly expand quotas and extend programs. This includes access to new funds through vehicles such as the Resilience and Sustainability Facility.
… Like 2023, we believe high yield/frontier bond returns will be the most compelling in 2024.
Ultimately, like 2023, we believe high yield/frontier bond returns will be the most compelling in 2024. Despite the lack of market access for numerous issuers, the strong multilateral support and alternative sources of financing provide ample room for spread compression, as well as for yields to fall.
EM local currency
The peak in DM rates looks likely to broaden the number of countries able to start their interest rate-cutting cycles. Inflation is falling (and, if anything, is broadly lower than predicted). Meanwhile, economic growth is generally weaker than forecast. Latin America has more room to cut, with economic growth less elevated and domestic wage pressures contained. Inflation in Central and Eastern Europe, Middle East, and Africa is more pervasive, although many countries should be able to reduce interest rates. Asia, by contrast, hasn't meaningfully raised rates and therefore has less capacity to cut as the year progresses. There are also countries not yet following this path, such as Turkey, Argentina, and Nigeria, where currency weakness and inflation remain a challenge to monetary policy.
During 2023, valuations became a little less compelling. Nonetheless, uncertainty about the macroeconomic outlook has tempered. As we highlighted, the Fed and European Central Bank could cut interest rates in the next 12 months. This could lead to another year of good EM local currency bond returns.
EM local bond yields
EM local bond yields, while not high versus US rates (risk premia are low), have consistently fallen during Fed-cutting episodes (Chart 2). Previously, yields followed US Treasuries, rallying before the first cut materialized. They've also delivered good returns following the first cut of each cycle on a foreign exchange-hedged basis.
We believe lower yields and duration gains will be the most significant source of returns for local currency bonds in 2024.
We believe lower yields and duration gains will be the most significant source of returns for local currency bonds in 2024. That said, there’s also scope for EM foreign exchange appreciation. The high carry built into numerous EM currencies is a supporting factor. The beginning of a Fed easing cycle also has the potential to take the wind out of the US dollar’s sails.
Chart 2. EM local bond yields have further to fall
Source: JP Morgan, December 2023.
EM corporate bonds
For EM corporates, credit fundamentals remain supportive despite recent volatility and the uncertain economic outlook. The credit rating trend turned negative in the second half of 2023. However, this was driven by pockets of the market rather than a reflection of broader weakness. In one of the first 2024 forward-looking data releases, JP Morgan forecasts a default rate of 4%. This compares with 8% for 2023 and reflects EM corporates’ broad credit strength. Slowing global economic growth will likely cause downward adjustments to operational performance. That said, leverage levels remain low while interest coverage is healthy. The asset class offers good value versus US corporates on an absolute spread basis, especially for BBs and BBBs.
Meanwhile, technical factors remain supportive. We expect net financing in 2024 to again be negative at -US$190 billion, with primary issuance a lackluster US$244 billion. Investor positioning in EM corporates is at its lowest level for five years, which is a favorable starting position. And we're likely to begin to see a reversal in flows should we see a significant fall in interest rates.
Final thoughts
In the primary market, the growing trend of green, social, and sustainability linked (GSS) bonds will increase as a percentage of overall issuance. The GSS bond market has been growing steadily (30% of volume in 2023 versus 5% in 2018) and now accounts for 13% of the EM corporate bond asset class. In our view, the relatively low or non-existent premium versus traditional bonds makes GGS attractive. They're also increasingly available to investors, which should continue in 2024 and beyond.
1JP Morgan, January 2023.
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