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A place to hide from rising rates – Cameron McCormack

As stock markets continue to fall in the face of the Fed’s hike, fixed income securities are attracting attention. Asset allocators, after being rattled by the historic bond sell-off earlier this year, are looking to relatively attractive yields. But developed market (DM) bonds are only part of the bond story.

Real policy rates in emerging markets (EM) are much higher. There are strong tailwinds for emerging market bonds, such as the GFC and subsequent debt crises when emerging market debt as an asset class shone. EM currently has the same basic fundamentals that made it successful and attracted flows back then:

  • Emerging markets have lower leverage and higher real interest rates compared to developed markets;
  • The authorities of the DM are forced into more experimentation and fiscal and monetary supplies, which creates greater risks.

Additionally, most global bond portfolios have no emerging market allocation, despite the asset class’s impressive risk/return characteristics.

Emerging market central banks are leading the charge and keeping it ‘real’

Emerging market central banks raised rates early and significantly, relative to the late DM hike cycle.

Exhibit 1: key rates in ME and in DM

Source: VanEck, Bloomberg.

Investors have always demanded a higher premium from emerging market issuers, but when looking at actual policy rates (rate minus inflation), the difference is stark and investors are being rewarded with emerging market bonds.

Chart 2: Real policy rates in MEs and DMs (%)

Source: VanEck, Bloomberg.

Emerging market policymakers are being inundated with dollars and rate hikes much earlier and more broadly than the Fed and other emerging market central banks, as they have been for every crisis of the past two decades. You can see surpluses as far as the eye can see below, despite the many global crises we have faced.

Exhibit 3: Emerging Markets Current Account Balance

Source: VanEck, Bloomberg.

Emerging markets could be the place to hide from rising rates

While DM bond yields have reached medium-term highs, investors eyeing bonds for yield are still concerned about duration, i.e. the threat that rates will continue to rise, eroding the capital. The chart below shows if you’re worried about duration, US Treasuries and investment grade bonds have much worse upside/downside characteristics than Emerging Market Sovereigns. Emerging market spreads are sufficient to better absorb rising rate scenarios.

Chart 4: Fixed income yields from -100 bps to +100 bps yield curve shift

Source: VanEck, Bloomberg, as of August 31, 2022. UST10YR is the Bloomberg US Government 10 Year Term Index, American GI is the American ICE BofA corporate index, US HY is the ICE BofA US High Yield Index, GBI-EM is local EM – JP Morgan Government Bond Index-Emerging Markets Global Diversified (GBI-EM); EMBIG is the hard currency of emerging markets – JP Morgan Emerging Markets Bond Index Global Diversified (EMBIGD) – EMBIGD is unhedged, EBND hedges its hard currency.

You might be missing out because most global bond portfolios have no allocation

One asset class that has been overlooked by Australian investors in the past and that can improve their yield is emerging market bonds. There are a number of reasons Australian investors may not have an emerging bond allocation based on old world beliefs, but we are entering a new world. Global comparisons show that many emerging economies are now as liquid and structurally sound as emerging markets, if not better. EM (the dark blue lines in the chart below) generally have stronger balance sheets than DM (the aqua lines on the chart). On many metrics, the G10’s savings are worse than the 26 largest EMs.

Exhibit 5: EM vs DM balance sheets

Source: Credit Suisse, JP Morgan, Bloomberg, BIS, Central Bank website.

Despite their stronger fundamentals, emerging market governments and companies typically pay more than their emerging market counterparts when issuing bonds. This represents an opportunity for opportunistic investors.

Considering the risk/reward ratio, as one would expect, the volatility of emerging market bonds is higher than emerging market bonds, but much lower than equities. The chart below also shows that since 2006, emerging market high yield bonds have suffered almost twice the risk of emerging market hard currency bonds for a similar yield.

Figure 6 – Efficient frontier of the bond portfolio, 2004 – 2022

Source: Bloomberg, VanEck, August 31, 2022. Results are calculated monthly and assume immediate reinvestment of all dividends. Volatility is the standard deviation of returns. You cannot invest in an index. Past performance is not a reliable indicator of future performance. Clues used: Cash – Bloomberg Australian Bank Bill 0+ Yr index; Global Bonds Hedged to AUD – Barclays Global Aggregate Bond A$ index hedged; Australian bonds – Bloomberg AusBond composite index; Australian Corporate Bonds – Bloomberg AusBond Credit 0+Yr Index; Australian Government Bonds – Bloomberg AusBond Australia Government Bond; GBI-EM is EM local – JP Morgan Government Bond Index-Emerging Markets Global Diversified (GBI-EM); EMBIG is the hard currency of emerging markets – JP Morgan Emerging Markets Bond Index Global Diversified (EMBIGD) – EMBIGD is unhedged, EBND hedges its hard currency; CEMBI – JP Morgan Corporate Emerging Markets Bond Index (CEMBI); Global HY AUD hedged – Bloomberg Barclay Global High Yield A$ index hedged.

We’ve discussed this before, but based on the 18 years of data above, through August of this year (including all recent bad spells), the implied efficient frontier allocation is around 20% of all fixed income securities to emerging market debt for 4% standard deviation, and above 60% for a standard deviation of 7%.

We do not recommend an allocation of this magnitude as a percentage of fixed income assets to emerging debt, nor are we asset allocators. We believe portfolios that continue to ignore emerging market debt will not survive bond stability, and if bonds rally, they will begin a major repricing. A dedicated allocation may be necessary, regardless, there is a strong argument for investors to consider an allocation greater than zero.

In the current environment of rising rates and selling off bonds, it seems like babies have been thrown out with the bathwater in all bond markets. Selectivity and vigilance, particularly in emerging markets, are essential.