Are we facing a favourable environment for investing in emerging bonds?
Updated:
12 JUL, 2024
Lisa Turk, Daniela Savoia, Romain Bordenave and Stéphane Mayor, emerging markets portfolio managers at Edmond de Rothschild AM, discuss the macroeconomic scenario for emerging market sovereign and corporate bonds.
The fundamentals of emerging market bonds, the Federal Reserve's monetary policy turnaround and the expected weakening of the dollar through 2024, may favour investment given their current diversification, size and maturity.
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Author: Lisa Turk, Daniela Savoia, Romain Bordenave and Stéphane Mayor, Portfolio Managers, Emerging Fixed Income, Edmond de Rothschild AM
The depth and variety of the emerging markets debt universe, requires a deep understanding of the issuers, the macroeconomic environment and the global debt markets.
We believe emerging market bonds have strong fundamentals in both the sovereign and corporate segments. We expect economic growth to stabilise and even improve across the region. In 2024, the IMF forecasts stable growth in emerging countries at around 4%, compared to a slowdown of around 1.4% in the developed world. The widening gap between GDP growth in emerging and developed countries should be very supportive for this asset class. Commodity prices are also a positive factor.
Emerging countries have always been used to managing periods of high inflation. In the current cycle, they have been much more proactive in raising interest rates, and this should also be true for rate cuts. In this respect, several emerging countries are ahead of developed countries in terms of monetary policy. This is particularly the case for Brazil, Colombia, Chile, Peru and the whole of Eastern Europe. The emerging countries' sovereign debt market has matured and has much stronger fundamentals.
We believe that the start of the rate cut cycle will be an important turning point. This is a very positive signal for emerging bonds. In 2022, we experienced a "Lehman Brothers" shock, when emerging sovereign bond prices fell sharply following the brutal rise in interest rates and the violent widening of spreads - the difference in yields to the risk-free rate. This double shock had lasting effects on emerging bond markets, creating opportunities that we can still take advantage of today.
On the corporate sido too, emerging market companies have improved their fundamentals in recent quarters, they are less indebted than their US counterparts. We strongly believe that emerging corporate debt offers attractive opportunities to invest in companies with quality management.
The drivers of performance should mainly come from interest rate in the second part of the year. The expected rebound driven by duration (rates) is likely to be substantial when the Federal Reserve (Fed) starts to cut rates. The flow component should also contribute to this effect as investors return to the asset class (in two years, emerging bonds experienced very large outflows, wiping out about 50% of the inflows of the last 15 years).
Again, the interest rate environment seems more favourable to emerging market bonds. A sharp drop in long-term rates could act as a catalyst and stimulate investors' appetite for risk. Since 2022, many investors have been content to invest in US bonds offering 5.5%, with little risk. They did not go looking for the excess yield - around 10% - that could be found in much of the emerging bond universe . The first rate cuts by the Federal Reserve (Fed) or the European Central Bank (ECB) could spur investors to seek yield and boost investment flows into this asset class again.
Focus on labelled emerging bonds
The market for green and sustainable bonds in emerging countries is growing rapidly: it now represents $900 billion, roughly 25% of the global market. Labelled emerging bonds offer similar yields to traditional emerging corporate bonds, but aim to generate a positive impact for the environment. The investment universe is also continuously expanding within this segment. While Asia accounts for 64% of labelled emerging bonds (green and sustainable), new diversification opportunities are opening up in other regions.
Climate investments in emerging markets are materialising on a large scale and generating positive impacts. Emerging countries can avoid the inefficient and polluting models of the past and move directly to low-carbon solutions.
As energy consumption increases, the financing needs for the energy transition in emerging countries are enormous. Emerging countries are expected to be responsible for 66% of CO2 emissions by 2030, but today they receive only a tiny share of transition financing. The reallocation of capital that this implies is opening up huge green investment opportunities in emerging countries. Moreover, according to the World Bank, investing one dollar in resilient infrastructure generates four dollars in returns, on average. We are convinced that green bonds are an effective way to fight climate change.
