Is it time to look again at emerging market bonds?

Arif Husain
Head of International Fixed Income at T. Rowe Price
Portfolio Manager for the T. Rowe Price Dynamic Global Bond Fund 

Emerging markets (EMs) have had a tough time over the past few years. The prospect of interest rate hikes in the U.S. prompted many investors to pull their money out of developing world assets—particularly local currencies—and channel their money instead into hard currency assets. China’s continued slowdown has also negatively impacted many emerging markets. 

But now the time may be right to look at the asset class again. Developed market bond yields remain at near-record-low levels, with some £10 trillion worth currently offering negative yields. While EM bond yields have also declined in recent months, they remain solidly in positive territory, offering a clear yield premium over developed market bonds. 

Fears that the U.S. might embark on an aggressive hiking cycle have eased. Even if the Federal Reserve raises rates again soon, it remains likely that the overall pace of hikes over the next few years will be slow, providing a more stable background for emerging markets. The recent stabilization of commodity prices has also been beneficial. A number of major economies are heading back to growth, and fears of a sudden slowdown in China have faded. For those willing to consider allocating to developing world bonds again, there are a growing number of opportunities developing in both bonds and currencies.

For example, some analysts expect South Africa’s bonds to lose their investment-grade status. In June, the country narrowly avoided having its debt downgraded by Standard & Poor’s from its current BBB- rating to junk status, but the ratings agency has maintained its negative outlook amid concerns about the consequences of low economic growth. However, we expect the South African government to do everything it can to maintain its investment-grade status. At the same time, the stabilization of commodity prices has helped the economy, the inflation picture is benign, and real interest rates are relatively high. As such, we believe the possibility of the debt being downgraded has been over-estimated by the markets, and the debt is therefore underpriced and offers good value. 

VIEW ALL

View all

The Mexican peso is similarly undervalued, in our view. There are various reasons for the currency's weakness, including the fact that it is the most liquid emerging currency (making it an ideal proxy for the asset class) and the negative impact of some of the recent comments about the country from U.S. presidential candidate Donald Trump. However, a combination of stable politics, market-friendly macro policies and progress on structural reforms mean that the fundamentals in Mexico are stronger than the currency value suggests. The peso therefore offers up a good buying opportunity at these levels. 

The emergence of new opportunities does not mean that the risks associated with emerging market bonds have gone away. The asset class remains highly heterogeneous, encompassing countries with markedly different cultures and challenges, and at different stages of their economic cycles. Identifying the best opportunities—and the biggest risks—requires in-depth research and analysis.

The ability to hedge risk through short positions is also invaluable. At the moment, for example, there is a strong case for being short on the Turkish lira. In our view, President Recep Tayyip Erdogan will do everything in his power to keep the country’s investment-grade rating to maintain a strong external face and retain the ability to finance cheaply, although the deteriorating scenario of extending autocracy, economic slowdown, and widening budget deficit may not prevent a downgrade. We also believe that Erdogan will be willing to allow the Turkish lira to depreciate, and as such the currency represents a good shorting opportunity.

Through highly selective investments in undervalued bonds and currencies, hedged by appropriate short positions, emerging market bonds are offering a strong and growing opportunity set for investors seeking yield. At T. Rowe Price, we are actively seeking to benefit from these opportunities through our Dynamic Global Bond Fund, which has a strong focus on downside protection to minimize exposure to the risks associated with the asset class. Given that developed world yields look set to remain low or negative for some time to come, we believe there is currently a strong case for increasing exposure to emerging market bonds through highly selective, risk-hedged allocations to the asset class.

Click here to learn more             

Important Information: Equity Trustees Limited (“EQT”) (ABN 46 004 031 298/AFSL 240975) and T. Rowe Price International Ltd (“TRPIL”) (ABN 84 104 852 191) are, respectively, the responsible entity and investment manager of the T. Rowe Price Australian Unit Trusts. TRPIL is exempt from the requirement to hold an Australian financial services licence in respect of the financial services it provides in Australia and is regulated by the Financial Conduct Authority under UK laws, which differ from Australian laws. For Wholesale Clients only.

Past performance is not a reliable indicator of future performance. The views contained herein are as of September 2016 and may have changed since that time. Unless indicated otherwise the source of all market data is
T. Rowe Price. The price of any fund may go up or down. Investment involves risk including a possible loss to the principal amount invested. For further details, please refer to each fund’s product disclosure statement and reference guide which are available from EQT or TRPIL.

T. ROWE PRICE, INVEST WITH CONFIDENCE and the Bighorn Sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc. in the United States, European Union, and other countries. This material is intended for use only in select countries.

2016-GL-4817