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Fund buyers plan to continue EM debt binge

Emerging market bonds have been on a strong run this year, and Europe’s investors think the rally isn’t over yet.


PA Europe

In the first five months of the year alone, net inflows into emerging market debt funds exceeded €30bn, an all-time record for the asset class over such a time period. Active funds continue to capture the bulk of flows into emerging market debt, though ETFs are gaining popularity in this asset class too (link naar passive/active). But investor appetite hasn’t yet been satisfied.

According to the latest Expert Investor asset allocation survey, investors across Europe are planning to further increase their exposure to emerging market bonds over the next 12 months. Net sentiment (those intending to increase allocation minus those planning to reduce it) has reached the second-highest level ever for both government and corporate emerging market bonds (see graph below).

And the reason for the continued enthusiasm for emerging market debt is rather obvious. Though EM corporate debt spreads have compressed significantly over the past year, absolute yield levels are still far above those in developed debt markets. In other words: emerging market debt is not really attractive from an absolute perspective, but it is when compared to other fixed income asset classes. As to illustrate this point: sellers outnumber buyers in developed market government bonds, investment-grade corporate bonds as well as high-yield bonds.

That’s also on the mind of Frank Reisbol, managing director at the private bank Carnegie Luxembourg. He has had an overweight to emerging market debt since the start of the year, with about a fifth of Carnegie’s total fixed-income exposure in EM debt. “We see little reason to change that, and plan to stick with this position.”

Going local

Reisbol’s overweight is in local currency bond funds, which have outperformed hard currency funds thanks to the appreciation of many EM currencies versus the dollar this year, with the average local currency fund returning 11.73% in dollar terms.

The local currency outperformance has been so striking that the worst-performing fund in this category has outperformed the best-performing fund in the hard currency, corporate bond category, according to Morningstar data.

Provided euro-based investors had hedged their currency risk, that’s a handsome return indeed. But there may be more to come: despite the double-digit returns this year, local currency bonds are still to fully recover losses suffered in previous years (see chart above).

Whether the local currency bond catch-up trade will continue, depends to a large extent on the performance of EM currencies versus the dollar going forward. EM currency exchange rates versus the dollar are still well below levels recorded three years ago.