Emerging Markets Debt Remains Fundamentally Strong

June’s massive bond sell-off, prompted by fears that the Federal Reserve would wind down its bond-buying program, has had a negative trickle-down effect on emerging market debt-dedicated assets, which were hit hard as part of the record $14.45 billion in outflows seen in the overall bond market for the week ending June 12.1

That week, emerging market bond funds recorded their second-largest weekly outflow of $2.53 billion, according to fund tracker EPFR Global. Emerging market equity funds fared even worse — representing $5.76 billion of the $8.51 billion in outflows seen by the total equity funds market for the week ending June 12.1

Depending on who you’ve asked, the sky has all but fallen recently in emerging markets, which have also been hampered by weak commodity prices, slowed growth and unresolved political risk.

But we believe the recent emerging market bond sell-off may be an overreaction by money managers and investors to unsettled US monetary policy. The fundamentals that make emerging markets an attractive asset class — such as higher growth, lower debt levels, abundant foreign-exchange reserves and a younger working population — have not changed. Similarly, on the emerging markets corporate side, the balance sheets and operational health of many companies remain strong.

While emerging market investors may be concerned about the recent strengthening of the US dollar, we view this as a buying opportunity as many emerging market issuers are now significantly undervalued.

Additionally, emerging market countries and corporations are better prepared to weather a change in US monetary policy. Moreover, many emerging market countries have shifted from policies in which the value of the local currency was fixed relative to the US dollar to more floating rate-oriented currencies, which can be a natural shock absorber to help emerging market countries deal with periods of volatility. Emerging market central banks also have larger foreign exchange reserves that can be deployed to combat further currency weakening.

Many emerging market corporations also have operational hedges, or “cushions,” that shield their revenues from abrupt movements in global liquidity and sentiment. These emerging bond issuers are able to offset declining revenues brought on by falling commodity prices with lower operating costs due to a weakening local currency. In fact, the strengthening of the US dollar could actually enhance these companies’ competitive edge. Other issuers execute foreign exchange (FX) swaps to match their expected cash flows into their local currency.

The added protections are the result of lessons learned from the 2008 credit crisis, which showed many emerging market countries and companies how difficult it can be to obtain funding when the global risk appetite turns negative.

Those of us with extensive experience handling this asset class know that emerging market debt goes through its share of ups and downs. The volatile nature of this asset class heightens the importance of fundamental research in assessing the risk of each opportunity.

Overall, we still hold a long-term positive view of the emerging market debt asset class, which has benefitted from strong investor flows over the past few years. This asset class has matured and become a predominately investment-grade asset class that we expect to continue to grow in the future.

1 Source: Reuters, “Bond Fund Outflows Top Record in Latest Week,” June 14, 2013

Important information

Foreign exchange (FX) swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Debt securities are affected by changing interest rates and changes in their effective maturities and credit quality.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues. An investment in emerging market countries carries greater risks compared to more developed economies.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.




All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is a US distributor for retail mutual funds, exchange-traded funds, institutional money market funds and unit investment trusts. Van Kampen Funds Inc. is a sponsor of unit investment trusts. Both entities are wholly owned, indirect subsidiaries of Invesco Ltd.

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