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Emerging Market Bonds: Time for Caution

Key Points
  • We suggest investors reduce or limit their exposure to emerging market bonds due to high valuations and rising risks.

  • Valuations: Yields for EM bonds remain near all-time lows, and the yield spread versus Treasuries has been trending toward 2007 lows. Investors aren’t getting much compensation for the risks in this segment of the bond market.

  • Risks: The Federal Reserve is tightening monetary policy and other major central banks are likely to follow in 2018, making it likely that financing conditions will get more challenging. The dollar has rebounded, which could make it harder for EM companies to finance their debt.

Emerging market bonds have been the strongest-performing segment of the fixed income market this year. The Bloomberg Barclays EM Local Currency Government Index has delivered a total return of 9.6% so far this year, while the Bloomberg Barclays EM USD Aggregate Index has returned 7.0%.1

An 8.2% drop in the U.S. dollar and very easy monetary policies in the major developed countries created a favorable backdrop for EM bonds in 2017.2 For investors, EM bonds have also provided added income and diversification to fixed income portfolios in a world where yields have been low for many years.

However, as investors worldwide have migrated to these bonds in search of attractive yields, we believe valuations have become stretched, and the underlying forces supporting high prices are becoming less favorable. Consequently, we are concerned that high valuations are increasing the risk of a correction. We see three key factors emerging that are increasing the risks in the EM bond market:

  • Central bank policies are tightening.
  • Bond yields are rising in most major countries. 
  • The dollar is rebounding.

Central bank policy

For the first time in eight years, the world’s major central banks are beginning to tighten monetary policy. In the U.S., the Federal Reserve has been raising interest rates since 2015 and is starting to reduce its bloated balance sheet. Similarly, the European Central Bank (ECB) is tapering its bond purchases and will likely end its quantitative easing program in the second half of next year. Even the Bank of Japan (BOJ) has shifted its focus to buying just enough bonds to keep bond yields near zero or slightly above, after having driven yields into negative territory in 2016.

The gradual shift in monetary policy, combined with improving global growth, has helped push bond yields higher in the major developed markets.

In fact, we believe the peak in central bank liquidity is behind us and that financial conditions will likely grow tighter. As central banks reduce liquidity and begin to nudge interest rates higher, bond investors should be able to obtain more attractive yields with less risk in these markets than in EM bonds.

Peak central bank liquidity

Total assets of major central banks have grown sharply but are set to fall next year.

Total assets at the Fed, Bank of Japan and ECB are now more than three times as high as they were in 2007.

Source: U.S. Federal Reserve (Fed), Bank of Japan (BOJ) and European Central Bank (ECB). Data as of 9/29/17.

Market valuations, however, haven’t adjusted to this prospective shift. The yield difference between EM U.S. dollar-denominated bonds and U.S. Treasuries is at its lowest level since 2007, just before the onset of the financial crisis.

EM spreads are near all-time lows

The spread between EM U.S. dollar-denominated bonds and U.S. Treasuries is around 2.5%, not far from the historic lows touched before the financial crisis.

Source: Bloomberg, using monthly data as of 11/14/2017. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.

The U.S. dollar’s rebound is another potential negative for EM bonds denominated in U.S. dollars. Although the dollar has fallen by more than 8% against a basket of currencies, it has been on the rise since September as expectations of further Fed rates hikes have increased. We expect a further moderate increase in the dollar due to widening interest rate differentials between the U.S. and other major countries. A stronger dollar could be particularly troublesome for EM companies that have borrowed in dollars over the past few years because U.S. rates were so low.

A stronger dollar will make it more expensive to service any debt that wasn’t hedged. Over the past decade of low U.S. interest rates, issuance of U.S. dollar denominated bonds by EM companies and countries has soared to $1.2 trillion from less than $200 million.

EM corporate debt has soared

Issuance of U.S. dollar denominated bonds by EM companies and countries has soared to $1.2 trillion from less than $200 million over the past decade.

Source: BofA Merrill Lynch U.S. Emerging Markets Liquid Corporate Plus Index (EMCL).

Finally, investors should keep an eye on the changing composition of the EM bond market. China is now the largest issuer of debt in the Bloomberg Barclays EM USD Aggregate Index, representing more than 17% of the index. Five years ago, China wasn’t represented at all. With the Chinese government trying to make companies reduce the leverage on their balance sheets, bond yields are moving up in that country. Higher yields in the domestic Chinese market could spill over into the global markets.

Composition of the Bloomberg Barclays EM USD Aggregate Index, 2007 and 2017

China now occupies the biggest chunk of the Bloomberg Barclays EM USD Aggregate Index, a big change from 2007, which it wasn’t represented on the index. In 2007, Russia had the largest weighting, at 19.6%.

Note: Chart shows the top ten country weightings of the index.

Source: Bloomberg Barclays EM USD Aggregate Index. Data as of 10/31/2007 and 10/31/2017. 

Our view is that at current yields and prices, the risk/reward balance in EM bonds isn’t attractive for most investors. There just isn’t enough yield to compensate for the risks, especially as the factors that have been supporting EM bonds—low global yields in developed markets, easy financial conditions and a soft dollar—are beginning to reverse. Consequently, we suggest investors reduce exposure to EM bonds until valuations are more attractive.

1Year-to-date total returns through 11/14/2017.
2Source: Bloomberg. U.S. Dollar Index, price level change from 12/31/2016 through 11/14/2017.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The BofA Merrill Lynch US Emerging Markets Liquid Corporate Plus Index tracks the performance of U.S. dollar (USD) denominated emerging markets non-sovereign debt publicly issued in the major domestic and Eurobond markets.

Bloomberg Barclays EM USD Aggregate Index includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia. As with other fixed income benchmarks provided by Barclays, the index is rules-based, allowing for an unbiased view of the marketplace and easy replicability.

Bloomberg Barclays Emerging Markets Local Currency Government Index is designed to provide a broad measure of the performance of local currency emerging markets debt. Classification as an emerging market is rules-based and reviewed on an annual basis using World Bank income group and International Monetary Fund country classifications.

The trade-weighted U.S. dollar index is a measure of the value of the dollar relative to other world currencies.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.

Investing in emerging markets may accentuate these risks. Currencies are speculative, very volatile and are not suitable for all investors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(1117-77YW)

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