Barings Reveals Outlook on EM Debt

istock_000004508721smallAn investment update was released from Baring Asset Management Head of Emerging Market Debt Thanasis Petronikolos. Comments below:

Against a backdrop of improving sovereign credit ratings and a generally positive outlook for most emerging currencies, increased investor interest has driven strong returns in recent months from the JP Morgan GBI-EM Global Diversified Index, a commonly used proxy for local currency emerging debt and the Benchmark Index for the Baring Emerging Markets Debt Local Currency Fund.

Year to date, the Index has returned 9.4% in US dollar terms, considerably ahead of both developed bond markets and high yield bonds. The Citi World Government Bond Index has returned just 0.7% over the same period, while the Bank of America Merrill Lynch Global High Yield B-BB Index has delivered a return of 7.5%.

While it is true that the income potential from emerging local currency debt is slightly lower than for high yield bonds, a typical coupon of around 6% is still attractive, in our view, and compares favorably with the very low yields on offer across a number of larger developed bond markets. At the time of writing, ten-year government bonds are yielding just 1.9% in the US market and barely 2.0% in the UK.

Where the asset class differs from developed sovereign debt is the potential contribution to investment return from currency appreciation, alongside coupon income and capital growth. Strength in emerging currencies against their developed counterparts has helped to keep long-term returns from local currency emerging debt ahead of hard currency emerging debt – and volatility lower. In fact, one of the characteristics of the asset class has been its resilience in the face of financial crises, including the 2008 financial crisis.

In the Baring Emerging Markets Debt Local Currency Fund, our investment approach combines strategic core investments with a medium to long-term investment horizon, with tactical positions implemented to take advantage of short-term opportunities in the market.

Our largest overweight position in the Fund relative to the benchmark index is a good example of the latter. Last year, our analysis of the market indicated that Hungarian bonds were undervalued due to tensions between the government and the central bank. We bought Hungarian bonds at a yield of 8.6% and the Hungarian forint when it was trading at 315 against the US dollar. Today, the yield is substantially lower and the currency has appreciated sharply as these tensions have eased, with officials from the European Union indicating that they believe the country’s central bank now has adequate protection from political interference.

Our scenario analysis, based on fundamental assessment of the prospects for the market and the currency under a variety of different outcomes, indicates that there is further appreciation from here. For the moment, therefore, we retain this position, which has been beneficial for investors in recent weeks, although we are monitoring the situation closely. Elsewhere, we remain underweight the Russian and Turkish bond markets on concerns about valuations, favoring Mexico and Brazil instead.