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Sector Inspector: Has patience paid off in emerging market bonds?

The search for income takes us to a sector that offers high yields but holds the risk of high capital loss.

Sector Inspector: Has patience paid off in emerging market bonds?

‘At least you’re paid to be patient.’ So goes the saying about high-yielding assets, which emerging market bonds certainly are, with average hard currency yields of 5% or more.

The question, though, is whether you are being paid enough. In the case of emerging market bonds, the answer is probably not. Even those high yields have not been sufficient to offset capital losses, with the average fund in Citywire’s hard currency sector having lost 1.6% over the past three years.

That admittedly compares favourably with the average loss of 18.6% within the local currency category over the same period, as it should for the notionally safer exposure.

Dollar coupon importance

Hard currency bond coupons are typically paid in dollars, whereas those receiving local currencies, such the renminbi, have to worry about devaluations. However, hard currency bond issuers need to have those dollars to meet their interest payments; they cannot simply print more of their currency to avoid defaults.

Tim Cockerill, investment director at Rowan Dartington, currently has no exposure to emerging market bonds but is considering the sector on valuation grounds if the rout continues.

‘I think a potential opportunity may be coming,’ he said. ‘Emerging market currencies have weakened quite considerably this year and there has been quite a big outflow of money from the area. I think there is an expectation that that outflow will continue and potentially accelerate.’

According to Bank of America Merrill Lynch, emerging market debt was the third-least popular asset class in the third quarter of this year. Investors pulled a net £10.4 billion from the sector, exceeded in redemptions by only emerging market equities and US equities.

China debt

Cockerill cited China as one risk factor in emerging market debt. ‘There is a lot of focus on the build-up of debt, and not necessarily good quality debt, within China since the financial crisis,’ he said. However, he added the sector ‘may become more interesting for us in a little while’, once valuations look compelling.

John Peta, head of emerging market debt at Old Mutual Global Investors, has already dipped a toe back into emerging market bonds after its re-rating, but only on a country-specific basis.

‘With the sell-off, we think that emerging market bonds are starting to look more attractive, and so just in the past week or so we have started to nibble a bit more on emerging market bonds in Russia, Mexico and South Africa – three countries that we think are pretty good credits, but have been pushed wider because of the general turmoil in emerging markets,’ Peta said.

Ariel Bezalel, the Citywire AAA-rated manager of the Jupiter Strategic Bond fund, was more cautious. ‘We continue to avoid emerging markets, and we do not really see the opportunities coming about as yet, despite the re-pricing of risk there,’ he said.

‘I think the problem in emerging markets is a protracted issue,’ Bezalel continued. ‘A lot of the emerging markets were reliant on the China growth story, which has now disappeared in my opinion. A lot of the structural or fundamental cracks that these countries have had for years have now come back to the surface.’

Bezalel has therefore focused on India for emerging market bonds, owing to its strong fundamentals and demographics, with a smaller exposure to Russia too.

Five-year total returns of funds generating the largest income in the sector

Source: Lipper. Source of sector average: Citywire. Performance is based on total return in UK pounds calculated gross of tax, bid to bid, ignoring the effect of initial charges and with income reinvested at the ex-dividend date.

Funds ranked in terms of income earned, assuming £1,000 invested over five years.

Hard currency bias

Andrew Balls, Citywire + rated chief investment officer for global fixed income at Pimco, added that hard currencies should also outperform local currencies in the months ahead. ‘One of the highest-conviction positions we have in our portfolios is to be underweight emerging Asian currencies versus the US dollar, reflecting the slowdown in the region and reflecting the policy easing in the region,’ he argued.

The trade-off between capital growth and income generation is illustrated perfectly by the Ashmore Emerging Markets Debt fund. This has paid out the most income to investors over the past five years, and boasts the highest yield in this selection, but is the only one of the top-five income generators to have recorded a capital loss for the period.

The Ashmore fund’s yield is produced through holdings such as Venezuelan bonds with double-digit coupons: they have continued to meet these payments, but negative sentiment surrounding their issuers and risk profile has forced down their prices.

In total, 54.4% of the Ashmore fund’s portfolio is allocated to non-investment grade debt, far more than the 37.9% weighting to junk bonds in its benchmark.

The second-highest yielder, Pimco Emerging Asia Bond, also has one of the least-impressive total returns for the period. Although being primarily focused on Asian bonds and hard currency debt, it also takes positions in issuers outside Asia and in local currencies. Brazil is currently its second-largest country allocation, for example, while the Mexican peso is a major currency exposure.

Balanced yield and total returns

Threadneedle Emerging Market Bond has generated more of a balance between yield and total returns, with major weightings currently towards Indonesia and Russia. Goldman Sachs Growth & Emerging Markets Debt Portfolio and Invesco Emerging Markets Bond have both sacrificed yield somewhat for far superior total returns, although their income records are still strong. The greatest allocation in the Goldman Sachs fund is to Latin America, although it also runs a large off-benchmark weighting to North America.

Invesco managers Joseph Portera and Rashique Rahman have struck a cautious note on the asset class for the remainder of the year. They said: ‘We expect volatility levels to remain elevated going into the fourth quarter as uncertainty around the timing of the US Federal Reserve’s decision on raising interest rates, the health of the US economy, and China’s economic slowdown impedes confidence in risk assets.’

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