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Is Emerging Market debt retaining its appeal?

Investors in search of real yields over the last decade had a significantly simpler decision when choosing to invest between Developed Market (DM) and Emerging Market (EM) fixed income assets. DM instruments offered investors very little in respect of yields compared to the more compelling and higher yields offered by their EM counterparts. In just two years the landscape has changed. Yields have risen substantially in the developed world, with the US 10-year Bond yield climbing to rates last seen before the Global Financial Crisis (GFC) in 2008 (as shown in the chart below).

Reassessing DM vs EM debt

In a very tough environment over the last year, EM equity and bonds have delivered a stellar relative performance. If conditions normalise, further upside is possible. From a downside perspective, high starting yields and coupons protect investors against rising rates given lower duration, a positive for EM bonds as an aggressive rate hiking cycle commenced. DM bonds, on the other hand, have been highly susceptible to downside risk with the value of these instruments dropping more and faster. Resilient global economic data at the beginning of 2023 suggests Central Banks, in their ongoing pursuit to lower inflation, will keep rates in developed economies higher for longer. The recent collapse of Silicon Valley Bank in the US and potential “banking crisis” may soften this policy approach however the need to reign in persistently high inflation remains critical. For EM sovereign bond holders, this is important as the US sovereign curve is the foundational block from which assets are priced. While the US sovereign yield curve potentially steepens, EM bonds are still offering sufficient yields, to compensate higher return seekers for the increased risk of holding their local country debt.

Inflation Linked Bonds (ILBs) provide a good indication of the real yields on offer. In the chart below we compare the real yields across a subset of countries that offer 10-year ILBs in their local currency.

South African ILBs are second only to Brazil in respect of real yields offered in the 10-year tenor.

EM: More than the yield

Investing in EM debt also offers investors diversification benefits. DM debt is typically issued by countries with similar economic characteristics, whereas EM debt can provide exposure to a wider range of economies with different growth drivers, political systems, and currency. This can help to mitigate risks associated with concentrated exposure to a single market or economic region. In the case of a strong US Dollar, this would be a particularly attractive reason for the addition of locally denominated EM bonds.

…but don’t forget the risk

At Truffle, we place a strong focus on understanding and assessing the risk, especially the downside risk.
Notwithstanding these potential benefits, the risks associated with investing in EM debt can be complex and may even differ across each market. Importantly in the current environment, EM economies may be more vulnerable than DM counterparts to:
1) Interest rate increases. Many emerging market economies have substantial amounts of foreign currency debt, which can become more expensive to service as interest rates rise.
2) Inflationary pressures. Higher costs can also impact the value of an EM currency and their ability to service their debt.
It remains critical to understand the specific risks and economic fundamentals for each EM region to ensure the higher yields and diversification benefits adequately compensate an investor.

Current dynamics: The fight against inflation

While inflationary pressures pose a considerable risk to EM economic growth over time, current inflation levels in the DM regions weigh on the real policy yields – impacting the short-end of the curve.

The chart above shows the prevailing policy rates across various DM and EM economies adjusted for current inflation rates. Monetary policy to tighten and protect against high inflation has been swift in many EM regions, resulting in real policy rates being higher than DM counterparts. These committees sacrificed growth to get ahead of inflation vs developing markets including the US FED who are “behind the curve”. Real policy differentials, similar to the real yields indicate EM instruments are also attractive at the short-end of the yield curve.

Balancing the risks and rewards

It’s important at Truffle, that as we assess changing market dynamics, we stay committed to our valuation-based philosophy while ensuring we take investment opportunities when they arise as we seek to meet client objectives. In South Africa, domestic bonds are presenting attractive high yields while adding diversification benefits to a multi-asset fund. We are mindful of the risks associated with investing in EM debt, including currency and political risks, and seek to implement risk mitigation strategies to protect our clients’ investments, when required. At present, we believe local SA debt is already adequately pricing in significant negativity and downside. While we are conscious of the current country specific risks, the health of the financial system provides support. We therefore view South African government bonds as a valuable component in our portfolios as we aim to provide superior risk-adjusted returns over the medium to long-term.

In summary

We believe emerging market debt continues to provide attractive investment opportunities for investors seeking higher real yields, with South African bonds a compelling choice, particularly at the longer end of the curve. EM instruments still offer diversification from DM debt in a portfolio, particularly in a rising interest rate environment. While some risks have changed in a world of interfering policy, the real yields offered by EM continue to compensate investors relative to DM. Implementing risk mitigation strategies to protect investments against some of these risks may be valuable.

EM debt continues to provide attractive investment opportunities to investors seeking higher real yields.

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