Emerging market (EM) stocks and currencies have posted volatile and disappointing performance this year amid concerns about slowing global growth and lower commodity prices. One investing surprise of 2015: EM debt denominated in U.S. dollars (USD) hasn’t struggled like its EM counterparts. Rather, it has been one of the best performing fixed income sectors of the year and has outperformed other EM assets, according to data accessible via Bloomberg.
For instance, this year through the end of November, EM debt in USD, as represented by the J.P. Morgan EMBI Global Index (EMBIG), returned 2.77 percent, outperforming EM equities, as measured by the MSCI Emerging Markets Index. Similarly, during the same time period, the EMBIG index outperformed the Barclays Aggregate Index, a bond market proxy.
EMD USD HAS OUTPERFORMED IN 2015
This outperformance is surprising not only because it has occurred amid pervasive negative sentiment toward EM assets, but also because it’s happening as the Federal Reserve (Fed) is poised to raise interest rates. The last time investors digested tighter monetary policy from the Fed in the summer of 2013, an event now recognized as the so-called “Taper Tantrum“, the EMBIG index suffered a -5.25 percent return that year, performance very different from what we’ve seen this year and last, according to data from Bloomberg
So, can the strong showing from EM debt in USD continue? To answer this question, it’s helpful to take a deeper look at what’s behind the outperformance.
But first, a quick reminder: It’s important to recognize that there are other drivers of EM credit performance beyond the factors that have led EM stocks and currencies to suffer in recent years. While both EM equities and currencies are often viewed as levered plays on commodities, their underperformance can also be attributed to lower global growth and reduced global trade. EM currencies, meanwhile, have particularly suffered lately as U.S. monetary policy shifts toward a less accommodative phase. As far as EM debt is concerned, it’s certainly not immune to these influences, but the following two additional factors are specific to the sector and have a lot to do with its strong performance.
Two Factors Impacting EM Performance
EM debt in USD can be divided into debt from investment grade (IG) countries and debt from high yielding (HY) countries. According to the components of the EMBIG index, IG countries’ debt makes up about two-thirds of the asset class, while one-third comes from HY countries’ debt.
Since April, according to a BlackRock analysis using J.P. Morgan data, debt from IG countries has contributed very little, or in some cases detracted, from the asset class’s total performance, while debt from HY countries has done the heavy lifting, as the chart below shows. While this positive performance is welcome, it hasn’t been broad based. For example, Russian debt, which received a downgrade to HY at the start of the year, is contributing 66 percent of the EMBIG index’s 2015 return.
HIGH YIELD HAS DOMINATED RETURNS
One may wonder, then, why EM debt in USD hasn’t performed similar to U.S. high yield debt, which is negative for the year. Both asset classes share similar risk profiles, with a simple distinction between foreign government and domestic corporate credit risk. A plausible explanation for the performance divergence is the issue of leverage. According to Barclays, some metrics of U.S. companies show leverage levels at the highest point since the 2008 crisis, and this may be leaving investors wary of deteriorating U.S. credit fundamentals. In contrast, EM nations as a whole are carrying less debt as a percentage of gross domestic product (GDP) than in years past, and thus the EMD index may have garnered relative attraction among investors searching for yield. That said, while EM governments seem to have cleaned up their balance sheets, overall leverage in total EM debt has increased due to the build up of leverage from EM corporates.
Because this EM debt asset class is denominated in dollars, its return is tied to U.S. Treasuries. The first part of this relationship is a spread component, or the extra compensation that investors earn for investing in riskier EMs. The second part of this relationship is the Treasury component, or the return that’s dictated by the movement in U.S. Treasuries. In other words, a decision to invest in EM debt in USD is also an implicit decision to invest in U.S. Treasuries.
For example, based on our analysis using J.P. Morgan index data, the EMBIG index’s 7.25 percent performance in 2014 is owed to a -0.35 percent spread return combined with a 7.6 percent Treasury return, as U.S. rates dropped significantly (remember that when interest rates fall, bond prices rise, and vice versa). And this year? Of the index’s 2.77 percent total return, about one third is owed to Treasury impacts.
Looking forward, with expectations of mildly higher U.S. rates next year, the positive Treasury impact we’ve seen the last two years may have been a gift that we shouldn’t expect to keep getting.
That said, I still expect the market segment to deliver modest returns next year, given the factors mentioned above and that rates are likely to rise gradually. EM bonds also look like a relative bargain within fixed income after this year’s spread widening. The bottom line: Even after the recent outperformance, EM hard currency debt is a fixed income asset class worth tilting toward as we head into 2016.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.
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