War, inflation and bankruptcy have dealt a particularly hard blow to emerging market bonds, and soured emerging market sentiment has generally not helped. But for intrepid investors, this corner of the bond market is already looking more attractive.
There is no covering up the pain. The
iShares JP Morgan USD Emerging Markets Bond
exchange-traded fund (ticker: EMB) has lost 15% this year, compared to the 10% loss in the
iShares Core US Aggregate Bond
Contributing to the pain is the Russian invasion of Ukraine, which led to indices pushing Russia away from their benchmarks, and to a rise in food and fuel prices that exacerbated the ill-fated fiscal health of countries like Sri Lanka, which said it was foreign debt would not pay .
But the market is ready to turn the corner, says Carlos de Sousa, emerging markets strategist with
fixed income group, which oversees $3.7 billion in assets.
The driving force behind an inflection point is diverging monetary policies around the world. Many central bankers in emerging markets, such as those in Brazil and Mexico, have been ahead of the Federal Reserve and have already raised interest rates to tackle inflation.
That’s a change from the past, when emerging markets often chased the Fed’s rate hikes, leaving them in a precarious situation as they struggled with rising borrowing costs.
Not only have they become more proactive, but many of the countries are in much better fiscal health than they were in 2016. They are less reliant on foreign-denominated debt, which should help them withstand the Fed’s tightening cycle better than they were during the so-called taper tantrum that year, as investors fled the asset class.
For those who have not yet invested in emerging markets, now is a good time to step in. One big reason: Funds have already taken the brunt of selling troubled securities and writing down investments, for example in Russian and Belarusian bonds.
That said, now is not the time for a passive approach. Here’s why: only emerging markets are attractive. Investors want to target the beneficiaries of the rise in commodity prices, such as Latin American commodity exporters, and avoid fuel and food importers whose finances could be under pressure.
Countries such as Mexico and Brazil are benefiting from the rise in commodity prices, and both are favorite areas for managers. Unlike emerging market equity benchmarks that focus on Asia, technology and trade beneficiaries, emerging market debt indices have greater support from commodity beneficiaries. That presents another opportunity for investors looking to take advantage of the commodity boom. But nuance is needed, with some countries in better shape and further away from crises than others.
Of course there are parts of the market that are under pressure, including frontier market countries like Tunisia, with shaky finances that are further strained by food shortages.
Sri Lanka’s sovereign bankruptcy is raising warning flags, but its condition is a byproduct of years of ill fiscal health. “It’s not a canary in the coal mine,” said Nick Hardingham, Emerging Markets Debt Director at
He adds that many emerging markets have taken advantage of low interest rates to improve their fiscal position and are not on the cusp of a series of dollar-denominated bonds to hit the market soon.
For those dipping their toes into it, dollar-denominated debt is the more conservative option. Local debt tends to be more volatile and may also be affected by the continued strength of the dollar.
write to Reshma Kapadia at firstname.lastname@example.org