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Time to Rethink the Role of Emerging Market Bonds

PART:
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Part 4
Time to Rethink the Role of Emerging Market Bonds PART 4 OF 10

Steady Climb in Emerging Markets’ Credit Ratings Challenged

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VanEck

Rating Trends Reflect Long-Term Emerging Markets Progress, Recent Headwinds

As we have discussed throughout this series, the health and stability of emerging markets has improved significantly in the new millennium. This historic progress has been well reflected in a steady improvement in the credit ratings of emerging markets bond markets as shown in the chart below. What has this meant for investors? An asset class that is less risky than it was two decades ago.

In the past three years, however, the asset class has encountered several headwinds, many of which are challenges that need be assessed country by country. From a credit perspective, these headwinds are reflected by the decline in the portion of the market rated investment grade.

Credit Ratings Have Improved Dramatically Since the Late 1990s

In the 1990s, the large portion of emerging markets with high yield ratings reflected a much riskier asset class, as demonstrated by the structural imbalances and economic challenges found in many emerging markets at the time. Since then, credit ratings among emerging economies have exhibited long-term improvement. The primary contributors have been steady economic growth, favorable fundamentals, and structural reforms which have made economies more flexible and less vulnerable to external shocks.

In 1997, only 14% of the J.P. Morgan EMBI Global Diversified Index (which tracks the investable U.S. dollar-denominated emerging markets sovereign bond market), was rated investment grade. By 2013, nearly 66% (or two thirds) of the Index was investment grade.

Steady Climb in Emerging Markets&#8217; Credit Ratings Challenged

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Since 2013, the long-term improvement in credit ratings appears to have stalled. Several recent headwinds including the slowdown in China, a stronger U.S. dollar, and the collapse in commodity prices had a significant negative impact on several emerging economies. Brazil and Russia, which both lost their investment grade status in 2015, have accounted for a large portion of the downgrades experienced over this timeframe. Other countries remain on the cusp of falling into non-investment grade status and may be downgraded due to economic or political reasons, or both. Further, the dire fiscal and political situation in Venezuela has been a reminder of some of the inherent risks of investing in emerging markets.

Opportunities Exist for Quality Focused Investors

With over half of the sovereign market rated investment grade, emerging markets bonds should not be viewed interchangeably with high yield corporate bonds or as inherently “risky.” Although there have been notable downgrades in the past few years, countries like Russia and Brazil appear to have stabilized and are showing signs of improvement. Further, there have been positive credit stories in countries such as Hungary, Indonesia, and the Philippines that should not be overlooked. Opportunities exist for quality focused investors to potentially achieve attractive yields versus developed market counterparts without having to go down the credit spectrum. More importantly, to the extent emerging markets continue to pursue structural reforms and enact policies that help foster economic growth, the asset class may benefit in the long term.

Steady Climb in Emerging Markets&#8217; Credit Ratings Challenged

Market Realist

Brazilian equities are running hot

Strong investor interest in emerging market debt (EMLC) (HYEM) has continued despite adverse political and economic issues in some countries. Brazil currently is running hot thanks to President Michel Temer’s policy reforms. Brazil’s inflation rates eased for five consecutive months to ~5.4% in January 2017, a level that hadn’t been seen since September 2012.

The easing came due to weaker demand and a stronger real, paving the way to steeper interest rate cuts and a stronger economic recovery in the coming months. Lower inflation means lower interest rates, and lower interest rates are good for stocks. That’s why the iShares MSCI Brazil Capped (EWZ) has risen 16.9% year-to-date, which is better than Russia, India, and even China.

The SPDR S&P China (GXC), the iShares MSCI India (INDA), and the VanEck Vectors Russia ETF (RSX) rose 11.0%, 9.0%, and 2.0%, respectively, in the same period.

To date, Brazil is turning out to be the “bae” of emerging markets. According to Rajiv Jain, a fund manager with GQG Partners, “There is a meaningful adjustment going on there in terms of policy and in terms of inflation that will spread throughout the economy, I think.” Jain’s exposure to Brazil has increased to 14.0% from 6.0% a year before and is currently higher on the equity side.

In the next part of our series, we’ll take a look at current opportunities in emerging market bonds.

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