Emerging market debt is perfectly placed to benefit from the economic recovery that will follow the current lockdowns. Especially local high-yield bonds are in a sweet spot, says Capital Group’s Luis Freitas De Oliveira.
‘It is hard not to agree with the consensus view that global GDP growth of 5-6% can be expected in 2021,’ says Freitas De Oliveira. ‘There is an enormous monetary stimulus just about everywhere in the world. And as profound and painful as the coronavirus crisis has been, there has been no damage to capital stocks or to the financial system, unlike in previous crises,’ ne notes.
‘It is as if someone just pressed a pause button. And now that the end of the pandemic is in sight, it should come as no surprise that there will be a strong recovery. And there is also a consensus that the US will lead the recovery as it exports much of its growth,’ adds De Freitas, who has worked for Capital Group for 26 years.
With emerging markets relying on US and other global growth, De Oliveira says EM bonds are ideally placed to benefit from the recovery, especially if the risk premium, which currently still is at a high level, were to fall. ‘This is especially the case for high-yield bonds. Ultimately, improving fundamentals and an attractive valuation are a very strong combination.’
However, De Oliveira cautions this picture would be less rosy if growth were to rebound too strongly and central banks were to cut back on their current accommodative policies. ‘That would be good news for the US dollar, which would weigh on commodity prices and also on many EM currencies. But that is not my base case scenario,’ underlines De Oliveira.
Dollar bonds less interesting
In dollar-denominated EM government issuance, which he finds expensive, De Freitas sees little opportunity anymore. ‘This was different during the market implosion in March 2020, when the biggest disruption in the financial markets was in the USD market. We then invested heavily in dollar bonds in both investment-grade and high-yield because the average yield was higher than in bonds denominated in local currency. So there was no need to take currency risk to generate additional returns! It was a very unique opportunity.’
Today, almost all the good news is priced in and there is not much room for further spread narrowing, he emphasises. ‘In addition, the EM bond universe in USD has changed enormously. Today, 60% of the universe consists of IG countries with a large weighting for Middle Eastern countries with at least an A-rating. These are mainly long-duration bonds, highly correlated to Treasuries and with very defensive spreads. Not something we want to invest in.’
Best opportunities in local currency
So De Oliveira sees more potential in local currency bonds, which have increased enormously in recent years. ‘This type of bonds has been the strongest growing part of the asset class for quite some time. Within the sub-segment, however, real yields vary widely. And we see a lot of opportunities to invest in cheap currencies and make good returns at the same time. Today, the situation has returned to normal and investors are once again being compensated for taking currency risk on board.’
And EM high yield is even more attractive, according to De Freitas. ‘The credit spread between IG and HY paper is at one of the highest levels ever seen. We find this part of the universe attractive with the bonus of a much shorter duration, less sensitivity than Treasuries and well placed to benefit from the reflationary theme.’
For the Capital Group fund manager, the corporate credit sub-market is often underexposed. ‘In the past, these bonds were treated poorly but that is no longer the case. Today, this segment consists mainly of issuers with a strong credit rating, mainly from Asia, who despite their safe character still offer a good return. Only a limited number of these is classified as high yield. Overall, this is a very safe sub-segment. This was clearly visible during the sell-off in March 2020. These issues did not fall as much and recovered faster.’