Emerging market bond funds saw net outflows each month from June 2015 to March this year, helped by the dismal performance of the asset class over the period. The JPM GBI-EM index, which tracks local currency government bonds, fell more than 15% in euro terms from the start of June 2015 to mid-February 2016. However, the index has recovered all of that lost ground since (see graph below). Returns from hard currency corporate bonds have been less spectacular, but they have also delivered double-digit returns year-to-date.
As recently as February, emerging market debt was deeply unpopular with European fund buyers. But since then, they have been riding the waves of the recovery. Until July, more than €18bn has flown back into the asset classes. These new flows have all but made up for the net redemptions of the previous nine months.
A relative play
Thomas Romig, head of multi-asset at Assenagon in Frankfurt, is an example of how suddenly investors sentiment towards emerging market debt can turn. He has gone from having no exposure at all in February to having his largest ever overweight now. “We have an allocation of our total portfolio [equity and fixed income] of 15 to 20%, the highest I had in my entire career,” he says.
As developed market bond yields have collapsed in the wake of the UK’s Brexit vote, the hunt for yield has taken front and centre for investors. And the only place where they can still find a combination of yield and decent credit quality is in emerging markets. “We made the switch to emerging market debt mainly from European credit,” says Romig, admitting his bet on EMD is to a large extent a relative play.
However, Romig prefers to stay on the safe side of emerging market debt for the moment. This is testified by two of his fund picks: the Aberdeen Select Emerging Markets Investment Grade Bond Fund, which invests in hard currency, high quality government bonds; and the Natixis Loomis Sayles Short Term Emerging Market Debt Fund. The latter fund isn’t even as exotic as its name suggests, having an exposure of 42% to developed market bonds.
But what about the fundamentals? Have they improved so much over a relatively short period of time to justify such a radical change of mood, considering the asset class has already delivered double-digit returns year-to-date?
Steve Drew, head of EM credit at Henderson, admits that much of the current appeal of the asset class is a relative story. “The fundamentals of emerging markets are a mixed bag. On the whole they are around the same as a year ago,” he says. “The flows and technical have dominated fixed income markets for the past years, and I expect them to continue to do so in the medium term.”
The recent history of QE in developed markets has indeed demonstrated that macroeconomic factors and investor demand can drive an asset class for a considerable amount of time. But there are other factors that speak for EMD, not the least of which is currency.
Local currencies have been a drag on the performance of the asset class through the years, but that has been different of late. Almost all major EM currencies have appreciated versus the dollar year-to-date, giving an extra boost to investors in local currency funds. And this rebound may well continue, as most of these currencies still trade well below their historical average.