Emerging Market Bonds
Article | 02 December 2016
Stuart Edwards and Asad Bhatti discuss how selective investments in emerging market bonds have been used in some of the fixed interest funds managed by the Henley team.
This summer, one area of the fixed income market that has experienced a large amount of investor interest is emerging markets. During one week alone in mid-July, data from EPFR reported by Barclays showed nearly US$5bn of inflows. This record level of investment represents a fivefold increase on more typical weekly levels for the sector.
The flows are likely due to the world’s ongoing search for yield and a general recovery in emerging market bond markets because of improving fundamentals. In an environment where five major central banks have negative interest rates, over half the global treasury market yields less than 0.5% and the European investment grade corporate bond market yields on average 0.7%, the attraction of a sector yielding over 4% on average is clear.
|European Currency High Yield Bond||4.59%||BB3|
|Emerging Markets Sovereign Bonds (Local Ccy)||4.60%||A3|
|Emerging Markets Corporate Bonds (External Ccy)||4.40%||BBB2|
|Emerging Markets Sovereigns (External Ccy)||4.26%||BB1|
|Sterling Corporate Bond (Investment Grade)||2.44%||A3|
|Euro Corporate Bond (Investment Grade)||0.70%||A3|
|Global Government Bonds (Developed)||0.50%||AA1|
Source: BofA Merrill Lynch. Data as at 31 July 2016. Yield is the yield to maturity.
At Invesco Perpetual, the Fixed Interest team has been making small, selective investments in emerging market bonds in the Invesco Perpetual Global Bond and High Yield funds for several years. As at 31 July 2016, the Invesco Perpetual High Yield Fund had a 4% allocation to the sector and the Invesco Perpetual Global Bond Fund a 7% allocation. Our investment in emerging markets is focused on identifying opportunities that we think provide stand-alone investment opportunities. This might be a high-quality corporate bond issuer or a sovereign bond we think attractively priced.
For us, investing in emerging markets, whether corporate or sovereign, begins with understanding the broader macroeconomic picture. For example, we want to understand what the likely effect of external factors such as US Federal Reserve policy would be. We then seek to understand the political structure, economic history and the governance of a country as well as macroeconomic indicators such as debt to GDP, currency reserves, economic growth and levels of trade, to form a view of the sovereign. To help us, we use the full breadth of the team’s macroeconomic resource. Alongside this, we also use third party research providers and have access to Invesco Perpetual’s dedicated emerging market equity teams with whom we can discuss ideas and views.
For corporate bonds, once we have formed a judgement on a sovereign we look at how the market is pricing in credit risk: one way we can do this is through the credit default swaps market. If we believe the sovereign is economically secure and attractively priced, we may look at corporate sectors within the country and individual corporate bonds that provide a good balance of risk and reward. Typically, because the corporate bond is priced off the sovereign, there will be a yield pickup versus a comparable developed market company. Of course, this higher yield reflects the higher sovereign risk, which is why we need to be comfortable with the macroeconomic picture in the first place.
Looking ahead, we are reasonably constructive on emerging markets. As outlined, the sector provides a significant yield pick-up over developed markets, which has been strengthened by recent central bank activity. However, purely focusing on yield can often be a recipe for disappointing returns, especially in the more volatile emerging market sector. There are, though, other factors that we think supportive of emerging markets in the near to medium term. Firstly, commodity markets have strengthened from their lows at the start of the year, providing a clear benefit to commodity producers, many of which are in emerging markets. Secondly, developed market central bank easing, alongside the US Federal Reserve’s cautious approach to monetary tightening provides a supportive backdrop for emerging markets. Thirdly, the better market conditions have helped support emerging market currencies and, in some cases, created the room for central banks to ease policy.
On the other hand, a more aggressive period of US monetary tightening cannot be ruled out and this is one of the key risks facing emerging markets. Another is for China to have a hard landing. China is a significant trading partner for many emerging markets and given its position as the world’s largest consumer of commodities, helps drive commodity prices. A hard landing would therefore likely see emerging markets come under pressure. There are also idiosyncratic risks, for example the recent political uncertainty in Brazil and South Africa. In many cases, though, as idiosyncratic risks play out, opportunities can occur. For instance, a change in government might lead to more investor-friendly policies.
Bringing this all together, emerging markets can provide opportunities. However, as ever, it is important to be selective and ensure that the balance of risk and return is appropriate.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
The securities that the Invesco Perpetual Global Bond and High Yield Bond funds invest in may not always make interest and other payments nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity for the securities in which the fund invests, may mean that the fund may not be able to sell those securities at their true value.
These risks increase where the fund invests in high yield or lower credit quality bonds and where we use derivatives.
The Invesco Perpetual Global Bond and High Yield Bond funds have the ability to make use of financial derivatives (complex instruments) which may result in the funds being leveraged and can result in large fluctuations in the value of the fund. Leverage on certain types of transactions including derivatives may impair the fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the fund being exposed to a greater loss than the initial investment.
The funds may be exposed to counterparty risk should an entity with which the fund does business become insolvent resulting in financial loss.
Where Stuart Edwards and Asad Bhatti have expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.
For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents, the Supplementary Information Document, the Annual or Interim Short Reports and the Prospectus, which are available from the Literature section.