To date, Emerging Markets (EM) fixed-income securities proved to be amongst the best performers within the asset class, despite scepticism that over the past years fundamentals have deteriorated.
Despite the recent turbulence, EM credit performed well, extending the gains made after the risk reversal in the second half of Q1, while FX and local market performance has been more volatile.
Looking at credit EM market, the Bank of America Merrill Lynch (EMHB) index, rallied with a year-to-date gain of circa 12.86 per cent, thus a strong outperformance primarily in confront of European High Yield (4.8 per cent) while US High Yield (11 per cent).
Despite investors might have been very cautious due to the fact that over the past months EM currencies were somehow conditioned by the instability of any U.S. hike, the more cautious stance brought about by Brexit pushed the said asset class towards stronger returns.
The UK Leave vote comes at a time when EM economic conditions are already fragile and China is attempting to manage not only a slowdown in growth but an economy in transition. Indeed, EM growth would have been lackluster even without the UK referendum shock. The manufacturing and confidence surveys for EM have been stable but not suggestive of accelerating growth from below-trend levels.
As yields in European High yield are now relatively unattractive in terms of risk-adjusted returns, investors fetched more attractive returns by shifting into EM hard currency debt. In fact, inflows into EM bond funds have over the past months increased in line with investors’ expectations in a pause in any hike and higher returns. As investors fear local EM currency, EM hard-currency flows fared much better than EM local market and equity flows.
The recent rally in EM dollar to date pleased investors. The question I pose is whether such rally will be sustained going forward. My perception is based on the fact that the recent rally in EM debt is primarily due to the fact of monetary easing in developed markets. In actual fact, EM credit fundamentals remain under some pressure. The EM rating trend has remained firmly negative, especially for oil-related issuers. Data compiled by Moody’s showed that the upgrade/downgrade ratio stands at 3:1 YTD, following a 5:1 ratio in 2015 (measured by debt volume across sovereign and corporate issuers).
Interestingly enough, some recent upgrades (Hungary, Serbia) and rating affirmations (South Africa) have mitigated the unappealing trend. Some EM countries might also be on the brink of a downgrade, with South Africa’s rating trend remains on a downward trajectory and risks to its investment grade status. Turkey also remains a potential ‘fallen angel’ candidate, although a downgrade to non-IG status is not imminent at this stage.
In my view, going forward we might experience a correction within EM hard currency debt, as fundamentals remain weak. That said, selectively, opportunities in particular sectors such as the telecommunications still offer investors attractive risk-adjusted returns with demographics and increasing demand being supportive. However, importantly investors should never get carried away by the high carry being offered by such bonds. Be extremely selective as risks are at elevated levels.
Disclaimer:
This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.