Given the recent strong performance for emerging market bonds, we have tempered our optimism about the potential for further spread tightening among the higher-rated segments. We remain, however, constructive on the asset class as a whole and still see attractive opportunities among lower-rated sovereign bonds, as well as selected local currency bonds.
Emerging market (EM) bonds saw broad-based gains in the first quarter of 2024, building on the asset class’s positive performance at the end of 2023. Given the recent strength, we have tempered our optimism about the potential for further spread tightening among the higher-rated segments.
However, we remain constructive on the asset class as a whole. We still see attractive opportunities among lower-rated sovereign bonds, as well as selected local currency bonds.
Macroeconomic risks remain: from uncertainty about the path of US inflation and interest rates, geopolitical risks, to the outcome of the US presidential election, but we expect inflows to remain supportive.
Together with a continued dearth of new EM sovereign and corporate bonds, we expect the relatively attractive yields offered by EM bonds to both add some downward pressure on yield spreads and act as a counterweight against higher yields should economic or political news provoke shorter- term volatility.
Positive on USD bonds, particularly selected HY
We continue to expect hard currency sovereign and corporate EM bonds to generate attractive returns in 2024, driven by an improving economic outlook and their relatively high yields compared to equivalent investment-grade US corporate bonds. But recent strength has tempered our optimism for significant further short-term capital appreciation.
Nevertheless, the fundamental outlook is supportive. EM countries, broadly speaking, continue to demonstrate economic resilience, largely due to strength in consumption and investment, and we expect growth to (slightly) exceed pre-pandemic levels into 2025.
Furthermore, some of the investment-grade and higher-quality (but still BB-rated) countries have already prefunded the bulk of their financing needs for 2024 and could access other funding channels such as the local markets if needed, making them less sensitive to the path of US interest rates. There is little reason, from a fundamental perspective, to be concerned about the outlook for investment-grade EM bonds.
While the lower-rated segments have become increasingly expensive, we believe compelling opportunities exist at the issuer level.
For example, countries such as Argentina, Ukraine, Egypt and Sri Lanka have recently seen significant improvements in their relationships with key stakeholders (which include the International Monetary Fund (IMF), the World Bank, and the Paris Club) on debt negotiations and fiscal support.
Argentina is in talks on an IMF support package, Ukraine is attempting to restructure its debt, and Egypt has received funding from the Gulf region. While these negotiations have been ongoing for some time and each country is in a different phase of the process, recent progress has been significant: broad frameworks have been achieved and agreements in principle have been finalised.
We are optimistic that in each case, a final agreement will be reached, providing a significant boost to the country’s creditworthiness.
EM investment-grade corporate bonds have rallied with the broader market since the beginning of the year. While in our view they are becoming increasing expensive, we believe they still offer value relative to their US corporate peers, and thus we expect them to continue to see support. They may see additional, if modest, spread tightening.
However, the additional yield offered by EM high-yield corporates relative to their US peers is more compelling. While EM corporate default rates (excluding Russia, Ukraine and the Chinese property market) are expected in be similar to those in developed markets, EM high-yield currently offers a sizeable spread over US high-yield.
Sector and security selection remains important, but we believe these relatively high-yielding assets should see further demand.
Cautiously optimistic on local bonds
Inflation continues to normalise across the EM regions, supporting the outlook for more accommodative domestic monetary policy and lower bond yields. We expect Latin America to remain the leader in implementing rate cuts and believe the bulk of the expected cuts will materialise in 2024.
Outside of Latin America, we expect the path of rates, while biased towards cuts, to depend more on both domestic data and to be more sensitive to the course the Fed takes.
However, we have adopted a more selective approach to local-currency EM bonds, largely due to uncertainty over the path of US inflation and its impact on the US dollar.
In the past few years, the strength of a basket of EM currencies has been highly correlated with the yield of the 10-year US Treasury note. If US inflation proves stubborn and lingers closer to 3% instead of declining towards the Fed’s long-term 2% average target rate, US yields could rise further, boosting the dollar relative to EM currencies. Furthermore, if US inflation were to persist at higher levels for an extended period, it could provoke a reassessment of the expected rate cuts in EM. This could have an outsized effect on the outlook for countries which are nearing the end of their efforts to implement looser monetary policy and countries where there is a higher degree of sensitivity to external conditions.
Disclaimer
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
