Are EM bonds back in favour

The inflation and interest rate turmoil that played out on global financial markets during 2022 has set the scene for a ‘golden age’ for emerging market (EM) fixed income investors, as developed market (DM) investors finally cotton on that their decades-long inflation holiday is over.

In a recent presentation titled ‘The tide is turning for emerging markets’, Lyle Sankar, Head of Fixed Interest at PGS Asset Management, said that now is a great time to be investing in the EM fixed income market. “Bond markets have come alive,” he said, before adding that to maximise performance from the asset class, fixed income asset managers and investors would have to pay close attention to factors such as fiscal risks in specific countries; out-of-control inflation; and the impact of central banks’ monetary policy decisions. 

Spectacular, sudden rotation from DM to EM

Sankar’s contribution to the PSG Summer Outlook event focused on the rotation of fixed income prospects from the DM to the EM. He noted that 2022 will go down in history for the rapid ‘take off’ of bond yields in Germany, the United States (US) and the United Kingdom (UK) following decades of lethargy. Overnight, the DM fixed interest marketplace has morphed from one of low inflation and negligible policy issues to one where surging inflation and concerns over the impact of higher interest rates on government debt hold sway. “DM bonds were so deeply mispriced [going into 2022] that the year-to-date performance of the bond market is the worst we have seen since 1926,” Sankar said. And it turns out inflation is the least of DM investors’ worries. 

US and UK central banks have become so complacent about inflation that they failed to heed multiple warnings over the build-up of inflationary pressure through 2020 and 2021. According to Sankar, the biggest mistake DM central banks made during this period was to focus on supporting their respective economies rather than fulfilling their primary objectives of keeping inflation in check. “In the first quarter of 2022, the US Fed Funds Rate was still at just 0.25% and the Fed was buying USD120 billion worth of US Treasury bonds every month,” he said, adding that the Fed simply ignored the myriad economic warning signs and proceeded with fiscal policies more suited to a low inflation environment. As we near the close of 2022, inflation remains a major problem for DM policymakers. 

Has lower-for-longer shipwrecked developed markets?

The lower-for-longer interest rate policy caused a bubble in DM bond markets, with bond valuations pushed to the highest levels in centuries. “We had the lowest yields since the 1800s contributing to the biggest bond market bubble in history,” said Sankar. This situation was only sustainable for as long as governments were prepared to buy negative-yielding debt; but this is no longer the case. Finally, the world has cottoned on that debt is not just an EM issue, with some of the highest debt-to-GDP ratios sitting in major developed markets. These bond markets have to contend with uncertain inflation in addition to funding national debts that are growing at a speed not seen in decades, so something has to give. 

Entering 2022 DM economies faced a toxic mixture of expensive equity markets; high inflation; and rising debt burdens, with most of these challenges still present as the year winds to a close. That explains why the so-called safe-haven of 50-year government treasuries ‘cost’ investors 37% in the US and 47% in the UK year-to-date November 2022. To put this shocking erosion of value in perspective, the MSCI World, which had a shocking year too, performed more than 15% better. And it gets worse. “There have only been three occasions since 1926 when bonds and equities have fallen at the same time; and 2022 was one of them,” Sankar said, before tearing into the Bank of England (BoE) for making a series of policy blunders that were a better fit for the laggards in the EM space. 

Soaring bond yields force a BoE about turn

By the third quarter of 2022, the UK fiscal and monetary policy positions were clearly out of sync, with fiscal policy promising billions of pounds to support the populace, and monetary policy positioning for austerity or belt-tightening. “The UK bond market shots u 2.5% in one month … with the BoE having to step in and buy back bonds after they were selling bonds in the initial stages of the year; this is something you would sooner see in Turkey than the UK,” lamented Sankar. The UK and other developed markets face structurally higher inflation and will be forced to exercise fiscal and monetary policy discipline. As a consequence, we are likely to see a rotation of high interest rates and inflation from the lower debt-to-GDP EMs into the higher debt-to-GDP DMs. To summarise, this developed market malaise is exactly what the doctor ordered for EMs, and more specifically, for commodity exporting economies. 

“Over the next decade, there are fundamental reasons why capital will shift from developed market bonds in search for yield elsewhere,” said Ané Craig, Assistant Fund Manager, PSG Diversified Income Fund. Top among these is the fact that UK and US policymakers are still grappling with the extent of the problem. There are also growing concerns that DM central banks are not taking the current inflation scenario seriously enough, with expectations that US inflation will be down to 2.5% in 2023 or 2024, and back to 2% by 2025. “Inflation is high today, and it will take a number of years to get back to central bank targets; DM bond markets are not pricing this in,” she said. Fixed income asset managers must, therefore, anticipate DM bonds to remain expensive and offer negative real yields for quite some time. 

South African bonds mispriced, in a good way…

PSG Asset Management expects a few good years ahead for fixed income in commodity exporting EMs, with South African bonds mispriced at current valuations. South Africa ticks five of six ‘check boxes’ to encourage global flows of capital, offering signs of fiscal improvement; long-term monetary policy stability; sensible yields and valuations; and a cheap currency. The only shortcoming, capital stability. “We are really excited about the investment proposition into South African government bonds today,” said Craig. “You can earn equity-like returns by taking bond levels of risk”. She dismissed the 2022 SA All Bond Index performance as an anomaly, reminding the audience that bonds had returned more than 3% above inflation in the six years prior. 

Fears over high inflation, rising interest rates and recession have left many financial and investment advisers, and their clients, wondering whether financial markets were broken. PSG Asset Management seemed upbeat despite the market turmoil, saying that their fund managers were still finding good opportunities for clients. “We want advisers to be able to confidently tell your clients that there are solutions that will help clients to reach their future financial goals; the turbulence we have witnessed through 2022 is setting the foundation for many good years of return,” concluded Sankar. 

Writer’s thoughts:
Bonds have always struck me as the most misunderstood of the asset classes. It is easy enough to wrap your mind around cash, equities or even listed property; but bonds remain mysterious, losing value as their yields go up! Do you agree or disagree with this view? And aside from the bond component in your client’s balanced or multi-asset funds, do you ever dabble in this fixed income opportunity? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.