Investors warned to tread carefully when venturing into emerging market bonds

Investment experts are urging caution against a headlong rush into emerging market bonds, which some fund managers are currently recommending as a “sweet spot” for yield-hungry investors spooked by market volatility.

Among those putting their weight behind this fixed income story in developing countries is Geneva-based Union Bancaire Privée, which is adding a frontier bonds strategy to its emerging markets sovereign bond franchise.

The Swiss bank’s investment strategists insist that while the UBAM Emerging Markets Frontier Bond fund is not a short-term play, the recent market sell-off provides an attractive entry point for new investors interested in putting their money into 35 frontier markets.

Emerging market watchers, believes lead portfolio manager Thomas Christiansen, are over-estimating the possibilities of developing countries, especially those in Africa, defaulting during the crisis. He is forecasting double-digit returns for his new fund, through a “deep fundamental knowledge and analysis of each country and security”. UBP also proposes a specific framework to address those bonds at risk of distress and potential defaults.

Overweight sovereign positions for UBP include Nigeria, where pain from a low oil price is balanced by a depreciating currency, because oil is sold in dollars, thus helping adjust current and fiscal accounts. The increase of the country’s debt load should be manageable, giving the low starting point.

Kenya’s “reasonably balanced economy” is also favoured by UBP, with low oil prices helpful for the importing country. Côte d'Ivoire, while impacted by the global crisis, will benefit from “decent macro-economic fundamentals, including a naturally fast growth rate”, believes Mr Christiansen.

Among Central and East European countries, Ukraine is seen as a compelling bond investment by UBP for its “positive reform stories” on both banking and land reform, despite continuing political turbulence and significant influence on the economy by vested interests. These include Ihor Kolomoyskyi, an oligarch in long-term dispute with the government over the ownership of Privatbank, previously Ukraine’s largest bank.

“Ukraine was a top performer in 2019, but has given back a lot of these gains in 2020, largely for self-inflicted reasons,” says Timothy Ash, emerging markets economist at Bluebay Asset Management. However, these barriers, including “a  badly-timed cabinet reshuffle and slow progress in putting a new IMF programme to bed” appear to be resolving.

Like other experts, Mr Ash calls for “intensive bottom-up credit work” to distinguish good from “more challenging” emerging market credits. “At the height of the [recent] emerging market sell-off…selling was pretty indiscriminate,” he says. “Many good credits were getting beaten up and there were some good buying opportunities therein.”

The UBP fund was launched with slightly more than $60m, expecting a $100m trading size, with a $1bn eventual capacity. UBP’s asset management teams currently manage SFr2bn in emerging market bonds, with a total AuM of SFr42bn ($43bn.)

Spreads for sovereign frontier bonds have more than doubled from 430 in mid-February to more than 1000 today, with yields moving from less than 6 per cent to 10.75 per cent today and topping 11 per cent in late March, according to UBP. The managers also feel bonds already in default are trading substantially below recovery value and expect active capital appreciation by buying defaulting bonds.

“Average recovery values are 60 cents on the dollar, while a number of bonds are currently trading in the 20s and 30s,” says Mr Christiansen. “Most fully distressed bonds offer significantly asymmetric risk from the positive side.”

He places sovereign bonds of Argentina, Ecuador and Zambia in this window of opportunity.

Others are similarly optimistic about the asset class, especially as oil markets stabilise and economies start to emerge from lockdown. “Global pension funds are still underinvested in emerging market dollar bonds,” says Simon Quijano-Evans, chief economist at emerging market-focused investment firm Gemcorp Capital. “These have demonstrated a more favourable risk/return profile over the past 10 years than many risk assets in developed markets, including equities and high-yield bonds.”

But while emerging market bonds may appear cheap in the short-term and are likely to offer medium- and long-term opportunities due to current market dislocation, Citi Private Bank recommends a more conservative approach, with a “focus on high quality names with more robust and defensive balance sheets” in volatile times.

Considerable challenges are posed today by oil and other commodity prices as well as economic and trade disruptions, says Roger Bacon, Asia-Pacific head of investments at Citi Private Bank. Citi expects this Asian region to be the most resilient and advocates continued caution.

While pointing to the expertise of smaller emerging market debt managers in finding “selective opportunities in smaller markets”, Mr Bacon also warns investors not to get too carried away with frontier markets with small GDPs, which can suffer from outflow pressure and local currency weakness, potentially destructive to capacity to repay or refinance debt.

It is also important to observe the actions of central banks in emerging countries and how they could distort asset prices and affect real economies. “Policymakers in emerging markets are increasingly resorting to the same tools used in developed markets,” says Nicholas Hardingham, portfolio manager in the Franklin Emerging Markets debt opportunities team. Central banks have been increasingly buying government and corporate bonds in Poland, Colombia, the Philippines, South Africa and Indonesia, he points out. Laws allowing monetary stimulus are also under consideration in Brazil and the Czech Republic.

Agnes Belaisch, chief European strategist at the Barings Investment Institute, agrees. “Emerging markets haven’t said their last word,” she says. “Massive portfolio investment outflows have led to large currency depreciation, but demand weakening is so large that central banks can ease policy rates without dangerously triggering inflation expectations.”

Although the space of fiscal spending to support economies may be limited by high indebtedness, she believes that asset purchases is one device in central bank toolboxes that is still underused. “A few EMs have a law in congress aiming to authorise central banks to do just that. If successful, this may prove a bounty for EM fixed income investors.”

UBP sees the Covid-19 virus as “mainly a 2020 phenomenon” with economies expected to pick up in 2021 or perhaps even in late 2020. But this view may prove too optimistic.

World trade was already weakening due to the build-up of global inventories in 2019, prior to the public health emergency, reports James Bevan, head of investments at CCLA. He expects most emerging markets to experience 15 to 30 per cent declines in export shipments, hitting production sectors and limiting ability to raise dollars through trade-related activities.

With an immediate and total reversal of lockdown strategies and subsequent boom in spending now looking like “wishful thinking”, Mr Bevan believes “trade trends may remain weak for at least the remainder of this year”.

A weaker dollar would be needed to boost emerging economies’ trade accounts, but today it is the capital accounts that dominate external payments balances and domestic liquidity trends across emerging markets, believes Mr Bevan.

While portfolio flows may yet rescue the fortunes of developing countries, a continuing Covid-19 crisis throws this recovery into doubt. “Against this backcloth, we don’t share the consensus preference for buying emerging market equities and debt.”