Attractive spreads in emerging market debt

Emerging markets have proven their economic and financial resilience. Attractive spreads and a lower volatility than US high yields make emerging market debt attractive. Further support comes from global trends.

External factors increase investor interest

The European Central Bank and the Bank of Japan pursue an even more expansive monetary polity since January. Moreover, the Federal Reserve will postpone additional rate increases, which makes it highly likely that interest rates in industrial economies will stay low or even negative for a longer time period. On their search for returns, investors are now willing to invest in more risky debt classes and debt issued in local currencies. 

However, the financial crisis, a reduction in Chinese economic growth and a price drop in oil have let to net capital outflows in 2015 - the first for a decade. These outflows worsen economic growth in emerging markets and foreign trade balances. Moreover, it increases the differences between the markets.

Fundamental resilience of emerging markets improved

Thereby, the pessimism of investors does by no means reflect the fundamental data of emerging markets, says Morgan Delledonne, Fixed Income Strategist, in ETF Securities’ outlook. Since the beginning of the millennium, emerging markets have made massive improvements regarding their taxation and monetary policies as well as their political stability. This has led to an increase in currency reserves and price stability, higher central bank credibility as well as a phase of economic growth and financial stability.

Emerging markets are still having their trade balances under tight control and remain financially solid. “The current unpopularity is no expression of the economic fundamental data and they therefore offer the opportunity to diversify and generate excess returns,” says Delledonne.

Attractive valuations and high spreads

2015 was a bad year for emerging market debt because investors feared a rise of the US-Dollar. Debt issued in local currencies, which account for 60 percent of the market, should profit from a stabilisation of the Dollar. Investors can thus make use of the higher interest rates paid on emerging market debt. Comparing them to German government bonds, they yield 4.6 percent more, despite having a lower volatility than US high yield bonds, says ETF Securities in their outlook.

Especially in regard to a global economic stabilisation, local currency debt can profit. Martin Arnold, FX and Macro Strategist at ETF Securities, says that emerging market currencies are likely to appreciate in favourable global economic conditions. He expects that an US rate increase will especially affect emerging market with high debt issued in Dollars and advises investors to diversify regionally.

Emerging market debt is thus having an attractive valuation but comes with the risk that the Fed shocks the market with a rate increase. Moreover, the countries could be affected by another worsening of their credit ratings. This will especially impact oil dependent countries, as it already did in 2015.