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Emerging Market (EM) Central Banks are well ahead of their Developed Market (DM) counterparts in controlling inflation by raising interest rates earlier and at a higher rate. As Jerome Powell, chairman of the Fed Reserve was claiming that inflation was transitory; Roberto Campos Neto, president of Brazil’s central bank, started a series of hawkish rate hikes. Campos Neto had already increased Brazil's key policy rate by about 900bps when Jerome Powell raised the Fed Fund rate by 25bps on17 March 2022.
As a result, Latin America countries such as Chile and Brazil already started cutting their key policy rates at the start of August this year. While emerging markets in Asia are showing signs of slowing inflation, these countries (excluding China) are more cautious and are expected to hold their interest rates at current levels, before cutting rates at the start of next year. Nevertheless, slowing inflation is positive news for fixed income investments as inflation decreases the purchasing power of income received in the future. In other words, EM countries with high interest rates and inflation on the downtrend, have attractive real yields now (nominal bond yields excluding expected inflation).
Moreover, investing in EM bonds offer diversification benefits. EM countries display different growth dynamics to DM countries. During economic downturns, EM countries have no choice but to engage in austerity and reforms, while DM countries often increase fiscal stimulus and accumulate debt - the result is that EM countries come out of recessions with strong, sustainable growth rates while DM countries' long-term growth rate is hampered due to the lack of deep recessionary reforms. According to projections by the IMF, global growth in 2023 and 2024 is poised to fall to 3.0% from 3.5% in 2022 (IMF). In an environment where growth rates are on the downtrend, investment in EM countries which are ahead in rate cuts and display higher productivity will demand a higher growth premium.
Emerging Market Bond Basics
Emerging market bonds are issued by countries (or corporations within those countries) that are in the process of transitioning to a developed economy with steady growth and lower political risks. There are broadly two categories of emerging market bonds. One that is issued in its domestic currency, known as local currency bonds; the other in a developed market currency, usually USD or EUR, known as hard currency bonds.
Local currency bonds are more liquid and volatile than hard currency bonds. Its liquidity is supported by stronger supply and demand factors - EM governments are increasingly looking towards their domestic market for financing while investors look for greater diversification and higher yields captured by the risk premium in local EM debt. EM local currency bonds' return are driven by local yields, their spread to DM market bond yields as well as changes in the exchange rate.
The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are a set of three indices (GBI-EM Broad, GBI-EM Global and GBI-EM) that track local currency bonds issued by EM governments. These three indices include different countries, to suit the needs of investors subjected to different capital, regulatory and tax restrictions. GBI-EM Global is the most investible index, including only countries that are directly accessible by most of the international investor base. This index includes government debt issued by 21 countries, such as China, Indonesia, Brazil, Chile etc. YTD total return on this index is 6% while YTD total return on the Bloomberg Aggregate Bond Index, (a broad-based U.S. investment grade bond index), is -4%. This demonstrates the attractiveness of investing in EM local bonds. The question now is, have returns on EM fixed income investments peaked?
Local Currency Sovereign EM Bonds Supported by U.S. Fed Rate Cuts
Imminent rate cuts by EM Central Banks are constructive for long duration local bonds as when interest rates fall, the price of the bond goes up. Rate cuts by the U.S. Fed is also a catalyst for EM government bonds as most of EM government debt is denoted in U.S. dollars - lower Fed rate means cheaper borrowing for EM governments, which in turns reduces the risk of default for EM governments laden with U.S. debt. Hence, I believe that yields on EM government bonds have not peaked. As global recessionary fears eases and DM Central Banks start cutting rates, the dollar will slide from its peak, leading to relative appreciation of EM currencies. Thus, EM local bond investors may reap capital gains as demand for higher yielding fixed income investments increases, as well as profit from local EM currency appreciation.
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