Emerging market debt, as an asset class, has been spared a big impact from the coronavirus so far.
Fear the virus will hurt the global economy has driven Treasury yields lower, and the easy money policies of the world’s central banks have pushed yields lower around the globe, so the hunt for yield has become ever more challenging.
Emerging market debt is a “least bad” choice, in the view of Brian Funk head of credit research at MetLife Investment Management. “It’s offering value on a risk-adjusted basis at this stage in the cycle.”
According to Bank of America, flows into emerging market debt funds as of last week were about $10 billion so far this year and they have been running at a record clip, aside from a small outflow the week earlier.
Some emerging markets bond spreads widened slightly Thursday, as risk markets sold off on reports of a surge in the number of counted coronavirus cases. Brennan Azevedo, emerging markets strategist at UBS Global Wealth Management, said most of the pressure in EM credit was coming from high-yielding debt, with Latin America the weakest region due to a sell-off in Argentina debt, unrelated to the virus.
“Overall, I would say that EM sovereign credit markets haven’t reacted much to the news overnight. My interpretation is that markets are monitoring for a potential spreading outside of China,” said Azevedo. He said Asian region debt widened slightly by 2 basis points Thursday to a spread of 163 over Treasurys.
But on a whole, emerging market debt has withstood the hit of the coronavirus, which has now infected more than 60,000 people, mostly in China and killed nearly 1,400.
“Markets initially reacted poorly to the coronavirus outbreak. However, spreads have more recently been supported by signs that the situation seems to be stabilizing, and therefore, we remain engaged. For the rest of 2020, we see spreads tightening 15bp,” wrote Citigroup economists earlier this week.
Funk said the bonds of countries with commodity-driven economies were harder hit as fears of the economic impact of the virus hit the prices of oil, copper and other commodities. “We still think of this at this stage as more of a short-term impact by and large. We think we’ll get better news in the next few weeks and navigate our way out of it,” he said.
The steep decline in Treasury yields since markets began to react to the virus in late January has actually helped the asset class. The total return for dollar-denominated emerging market sovereigns and corporate bonds has been positive since the virus began spreading on a large scale.
“They returned a half percent since Jan. 22, which we can pick as the day of an increase in concerns,” said Alejo Czerwonko, emerging markets strategist at UBS Global Wealth Management. Czerwonko, speaking Wednesday, said the spread for the JPMorgan emerging market bond index, covering 73 dollar-denominated sovereigns, was 295 basis points, on Jan. 22 and as of Thursday it was at a spread of 302 basis points over Treasury yields.
“This is pretty good return for fixed income since we’re talking about this asset class that could be directly or indirectly affected by virus concerns,” said Czerwonko. “It has held up pretty well…The reason behind this relatively good performance has to do with the drop in U.S. treasury rates and with emerging market sovereign spreads not selling off at the same time.”
Individual investors can dip into the EM space through funds or ETFs, as Franklin LibertyQ Emerging Market ETF FLQE, which pays almost 6%. It’s heavily exposed to Asia, India and Russia. EMB, the iShares JPMorgan USD Emerging Market Bond Fund ETF is based on the JP Morgan emerging market bond index and is up about 1% in the past month and 1.2% for the year so far. In 2019, the ETF was up 10.3%. EMTL, the SPDR Doubleline Emerging Markets Fixed Income ETF is up 1.1% in the past month and up 1.9% for the year-to-date.
But Czerwonko said he dropped his overweight rating on the asset class several weeks ago. In 2019, the total return for EM dollar denominated sovereigns was 14.4% and he expects just mid-single digit returns this year.
“Taking a longer time frame for instance since the beginning of 2019, in early January country risk or once again the spread of dollar denominated emerging markets bonds was 410 basis points,” he said. “Throughout 2019, it came down all the way to close to 300. We saw a pretty dramatic fall in spreads. Spreads falling means yields falling, which means prices rising so the valuation of the asset class became less attractive.”
But still, strategists see value though investors should also beware of risks.
S&P Global Ratings said it sees the outbreak as a “high” risk in Asia-Pacific and especially China. It said, in a report earlier this week, that there is an “elevated” risk for the rest of the world as of now, due to much lower infection and death rates outside China.
“We expect there will be a short-term effect on China’s and global GDP growth, as well as some economic cost for industries most exposed to Chinese household spending and the increasing containment measures more broadly,” the ratings analysts wrote. They assumed, in their report, that the virus would be contained by March.
“In our baseline, we estimate that the virus could lower China’s GDP growth by 70 basis points (bps), to 5.0%, this year, with a peak effect in the first quarter before a rebound begins in the third quarter, and lost output largely recovered by end-2021. In turn, it would trim 30 bps from global GDP growth this year,” the S&P analysts wrote.
Goldman Sachs strategists said emerging market rates can continue to benefit, even during a growth shock. “If, as in our base case, the viral outbreak has a significant, but temporary and contained, impact on EM growth, EM local rates can continue to benefit, as policymakers may not look through – but may seek to cushion – even a temporary growth shock,” the strategists said in a note.
Citigroup said its main overweights are South Africa, Russia, Ecuador and Sri Lanka and main underweights include Mexico, Peru, El Salvador and Croatia. It said investor positioning data shows the largest overweights are Brazil, Meixco and Ukraine and the largest underweights are Qatar, China and Russia.
Brazil’s 10-year bond was yielding 6.48% Thursday, while Mexico was yielding 6.57%. China’s yield for its 10-year was 2.87%. The U.S. 10-year was yielding about 1.60% Thursday.
Citi strategists said they had taken profits in Argentina, reducing their overweight. A debt payment by the Province of Buenos Aires temporarily drove prices higher, and the strategists went overweight via the PBA bonds and then took profits.
On Thursday, Argentine bonds were hit hard after the economy minister warned that a “deep debt restructuring” was on the way and the government would take a tough stance with the country’s creditors.
The spread between Argentina’s bonds and U.S. Treasurys was 2,068, according to Reuters.
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