May 21, 2021 Fixed Income

Unsafe havens? EM bonds come of age

Rising Treasury yields have historically been anything but bad news for emerging-market bonds. In fact, most of the time this has even reduced their risk premium. Don't underestimate them.

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The capital market is supposedly rational but in fact not free of prejudices and old thought patterns. Emerging markets (EM), for example, still must contend with the reputation that they only attract fast money which will quickly flow back into supposed safe havens in the event of turbulence – or if the havens begin to offer more attractive yields.

Owners of emerging-market bonds have been hearing exactly that for more than half a year: their asset class is becoming less attractive given rising U.S. bond yields. Of course, the first thing to note is that the first victims of rising U.S. yields are U.S. Treasury bondholders. Whether this loss eventually proves larger or smaller for holders of emerging-market bonds depends heavily on how the "spread" develops. This spread is the risk premium paid over the supposedly safer developed country benchmark bond. If, as a result of higher Treasury yields, money was to flow from emerging markets to the United States, EM bond spreads would have to widen, putting even more pressure on prices.

20210521_Cotw_EM bonds_CHART_EN.png

Sources: Bloomberg Finance L.P. and DWS Investment GmbH as of 5/17/21

 

Emerging markets are on a sounder macroeconomic footing today than they were a decade or two ago.

As our Chart of the Week shows, however, this has not been the case. On the contrary, spreads have mostly tightened when U.S. yields have risen. Thus, the price loss that accompanied the increase in Treasury yields was partially compensated.

This is even more important as the many negative headlines on EM bonds may confirm the impression that emerging markets deserve a large risk discount. We, however, believe that the spread more than adequately reflects the current risks. Overall, emerging markets are on a sounder macroeconomic footing today than they were a decade or two ago. In addition, growing demand from local investors is providing more stability. Add rising commodity prices and the backdrop appears to be pretty positive in our view.

But of course, this asset class remains very heterogeneous. Whereas in 2020, after the collapse in capital markets in the spring, investors had plenty of opportunities to generate more than decent results, this year they will have to be more selective. In many EM countries, spreads have almost shrunk back to pre-Covid levels, while other countries are still trading well above them. Bonds with investment-grade rating are averaging a spread of 152 basis points (bps), just above their previous lows. In the high-yield segment the spread is currently 600bps, more than 100bps above the pre-crisis lows. By way of comparison, U.S. corporate bonds only offer half these spread premiums on average.

Even if it cannot be ruled out that political headlines continue to cause volatility in emerging markets in the short term, we believe that longer-term investors should consider overcoming old thought patterns and paying more attention to EM bonds, for diversification reasons at the very least.

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