After the Federal Reserve surprised markets by not reducing the pace of their asset purchases, yields on fixed income securities corrected sharply. With the prospect that Chairman Bernanke may now refrain from reducing stimulus before his term expires, sentiment within fixed income markets appears to be improving. In light of these recent events, where does it make sense for investors to add incremental risk to their bond portfolios?
In our opinion, investors should consider increasing their exposure to emerging market (EM) fixed income:
• Long-term fundamentals broadly intact: While a few EM countries seek to reduce external vulnerabilities, the economic fundamentals of many EM countries remain intact from our perspective.
• Sell-off has been overdone: The extent of the sell-off in recent months has created attractive entry points for both EM currencies and fixed income relative to other sectors.
• China appears resilient: The combination of stronger growth and improving sentiment contrasts with the headwinds faced earlier this year.
Within emerging market fixed income, it is important for investors to determine what risks are worth taking. EM corporate credit and EM local sovereign debt will have very different potential drivers of return going forward. In part one of this two part series, we examine EM corporate credit as an alternative to other U.S. dollar-denominated fixed income.
Specifically,
• U.S. corporate bonds are trading at levels near their 12-month average; emerging market corporate bonds have sold off along with other emerging market assets
• EM corporate bonds appear attractive compared to U.S. corporate debt
• EM corporate credit touched the closest relative levels to U.S. high yield in its history on September 5, 2013
EM Corporate Credit
Similar to U.S. corporate bonds, EM corporate bonds are primarily denominated in U.S. dollars and trade at a spread relative to U.S. Treasury bonds. As a consequence, investors are exposed to changes in U.S. interest rates when investing in EM corporate bonds. In an uncertain interest rate environment, the potential value from investing in emerging market corporate credit is achieved through exposure to securities that provide a sizable yield cushion that can potentially dampen principal losses should rates rise.
