Fund Managers See Caution Signs in Emerging-Market Bond Rebound
Portfolio managers are wary of remaining risks and building up cash Christian Sewing, chief executive officer of Deutsche Bank AG, speaking in Berlin last month during the Christian Democrat Union Business Day. Firms like Deutsche Bank have cut staff in their emerging-market bond departments.
Emerging-market government bonds have bounced back from their decline in the first half of 2018, but many bond-fund managers aren’t buying the rebound.
Individual investors put about $100 million into emerging-market debt mutual funds in the second week of July as prices rose, reversing months of outflows, and adding to $13 billion they had already invested since mid-2016, according to Lipper. Rising dollar-denominated bond prices in July erased more than half of the losses from the first half of the year, showing the appeal of high-yielding bonds issued by nations including Argentina, Egypt and Brazil at a time of solid global growth and low interest rates.
Yet portfolio managers who focus on emerging debt remain lukewarm, zeroing in on signs that the debt remains risky despite price declines earlier in 2018. A survey of emerging-market debt investors conducted by Citigroup in early July found increasingly bearish sentiment compared to the second quarter, with more respondents building up cash in expectation of further price declines and 50% believing a full-blown trade war will break out. Trading and issuance remain below year-earlier levels, and firms like Deutsche Bank AG and Nomura Holdings Inc. have cut staff in their emerging-market bond departments.
Among the key concerns voiced by many bond managers: A resurgent U.S. dollar could take off, reigniting fears about debt sustainability and economic resilience in countries whose debt-servicing capacity stands to decline as local currencies depreciate.
“There are very strong and sometimes opposing forces that make this a very challenging time,” said Henry Peabody, co-manager of an $810 million global bond fund at Eaton Vance. About half of the fund’s investments are in emerging markets, but Mr. Peabody is keeping about 12% in cash in anticipation of further downturns. “If we see a more pronounced dollar rally, that’s when we want to buy, when others are forced sellers,” he said.
Buying dollar-denominated emerging bonds paid off in 2017, with returns around 8%, counting price changes and interest payments, according to Bloomberg Barclays data. This year, trade tensions have rattled these markets and saddled emerging-market bondholders with an average loss of about 2.6%, as of Friday.
The managers’ caution underscores an unhappy fact about emerging-market sovereign bonds issued in local currencies: On average, they haven’t returned much given their well-chronicled risks, ranging from economic volatility to political upheaval.
Local-currency emerging-market bonds delivered average annualized total returns of almost 3% over the past 10 years. Over the same span, U.S. investment-grade corporate bonds returned 5.6% and U.S. junk-rated corporate bonds 8.4%, according to data from Bloomberg Barclays Indices. Dollar bonds have returned more than local-currency ones but have been more volatile than U.S. junk debt, the data show.
“What we’ve seen in emerging-markets debt, frankly, over the years is a lot of downside and not enough upside to offset it,” said Wade O’Brien, a managing director at Cambridge Associates who advises foundations and endowments on bond-market investing. He recommends clients trade in and out of emerging market tactically, rather than dedicating a fixed percentage of their portfolios to the asset class the way they do U.S. stocks and developed-market bonds.
Borrowing by emerging-market countries surged after the financial crisis as low interest rates in the U.S. and Europe pushed institutional investors to scour the globe for higher-yielding investments.
Government debt in the top 30 emerging markets more than doubled to $15.2 trillion since 2009, mostly through the issuance of local-currency debt that was increasingly sold to foreign investors, according to the Institute of International Finance, or IIF. Foreign ownership of government bonds has doubled in many emerging markets over the past decade and exceeded 30% in countries including South Africa, Malaysia, Peru and Russia as of March 31, according to the IIF.
When the aftershocks of the crisis faded, emerging-market fund managers predicted a new age of better regulation and financial stability would damp the political risks that historically plagued emerging markets.
“Years of progress toward better governance and mature financial markets have allowed emerging-markets debt to establish deeper and broader support from investors,” investment firm Nuveen said in a December research report.
But recent selloffs in Turkish and Argentine government bonds offer a reminder that there is a potential price to be paid for that support. The Turkish Lirahaslost around 20% this year against the U.S. dollar, and the Argentine peso has fallen about 33%, the two worst performances in a basket of currencies tracked by The Wall Street Journal.
Local-currency investments can be treacherous, but another fast-growing type of emerging-markets debt, corporate bonds, compares favorably to most developed markets, says Jeff Grills, a portfolio manager at emerging-markets asset manager Gramercy. Emerging-markets corporate bonds returned roughly 7.5% over the past 10 years, according to data from JPMorgan Chase & Co., near U.S. high-yield bonds.
Some bond-fund managers are leery even of corporate bonds in emerging markets for fear of more turmoil. Much of the growth in corporate debt has been in China, where nonfinancial corporate debt now amounts to 163% of gross domestic product, according to IIF data, and investors are worried about a potential default spike.
“If anything we are underweight emerging-market corporates because of the China exposure,” said Rachel Golder, co-head of high-yield investments at Goldman Sachs Asset Management.