Tide turning for hard currency EM debt

Inflows are returning to emerging market debt as valuations are attractive from a historical perspective and relative to developed market bond yields, according to NN Investment Partners.

Spreads on hard currency emerging market debt versus US Treasury yields are currently still high historically at about 400 basis points, even after the 100bps rally seen since February,.

The rally was from the highest point of the last six years, meaning valuations on HC EMD are still attractive, especially versus the current levels of government bond yields in the G3 economies, NN IP says.

Marco Ruijer, lead portfolio manager of NN IP’s Emerging Market Debt Hard Currency Strategies, commented: “Emerging markets have experienced a rollercoaster ride in the past few quarters and volatility is likely to stay for a while. Looking at EMD HC, the key things to watch in the coming weeks and months are the oil price and the intentions of the OPEC, the current developments in the Chinese market and the intended rate trajectory of the US Federal Reserve.

“Further on the horizon, things are falling into place for EMD. The fundamentals show there are some green shoots in terms of better Purchasing Managers Index numbers, virtually across the entire globe. It seems that the global concerns will fade away further, as some stabilisation is seen. Next year, growth in EM can finally pick up somewhat, which bodes well for the asset class. Also the depreciation of EM currencies in the past few years will be a big help for the net export positions, while the currency appreciation we have seen more recently will help to improve the debt indicators somewhat.”

Technical factors are improving due to more inflows from both retail and institutional investors. NN IP believes these could accelerate if yields in developed markets remain low and fundamentals continue to improve. However, liquidity is still an issue; during the sell-off in the first six weeks of this year it was almost impossible to sell bonds at a reasonable price and when the market recovered it was very hard to find bonds to buy, resulting in volatility.

NN IP says its EMD HC portfolio is overweight in Africa, with preferences for Cameroon, Angola and Zambia. In Brazil, the portfolio was slightly overweight at the beginning of the year, which was good given the rally, but it is currently neutral. NN IP says it is underweight low-yielding countries such as Poland, Latvia and Lithuania. The corporate exposure in the portfolio is around 7 percent, which is around historical low levels, because NN IP currently favours sovereign bonds over corporate bonds.

Brazil is still high on NN IP’s watch list. Brazilian bonds have rallied this year based on the expectation that President Dilma will be impeached. Now that the probability of impeachment has clearly increased, the initial euphoria of markets could give way to caution as investors will look for hints of what policy would look like in a new government led by Vice President Temer. In Venezuela, the probability of the country defaulting on its debt is still very high while South Africa has seen a lot of political turmoil recently too.

Ruijer added: “The new government in Argentina is doing very well but it has some way to go. The stabilisation in China has been encouraging; the authorities have set a growth target for this year of 6.5 percent and we believe this is achievable while real estate prices and volumes are rising.”