Global investors have raised their holdings of emerging market bonds to a three-year high, even as average EM sovereign credit ratings have plunged to their lowest level since early 2010.
The unusual move is a sign of an increasingly desperate hunt for yield in emerging market bonds, irrespective of the apparent decline in credit quality, at least in the opinion of the major rating agencies.
EM paper accounted for 11.5 per cent of the assets of the bond fund industry at the end of November, according to data collated by the Institute of International Finance, an industry body, up from a low of 9.7 per cent in February 2016, the nadir of a three-year sell-off in the wake of 2013’s “taper tantrum”.
However, following sovereign downgrades for countries such as China, Brazil, Turkey, South Africa, Nigeria, Chile, Ecuador and Lebanon this year, perceived credit quality has moved in the opposite direction.
This measure is based on the average rating for around 30 emerging market countries awarded by Fitch Ratings, Standard & Poor’s and Moody’s on a scale of 0-20 where 20 represents AAA, 11 is BBB-, the lowest investment grade, and 0 is default.
“One of the risks that we highlight to our clients is that the so-called ratings momentum of the asset class remains negative,” said Bryan Carter, head of emerging market debt at BNP Paribas Asset Management.
“Even though we are quite bullish in terms of the indicators we look at, we acknowledge that the rating agencies continue to downgrade EM countries and that is a headwind for the asset class.”
The divergence between rating actions and flows is highly unusual, given that changes in bond allocations have tended to closely follow sovereign ratings in recent years.
Hung Tran, executive director at the IIF, said many fund managers had raised their allocations to EM bonds, despite the downgrades, because of a “divergence” between credit ratings and yield spreads over US Treasuries, which made EM bonds unusually attractive, allied to the success of the carry trade: borrowing in dollars and investing in higher-yielding emerging markets.
Moreover, low levels of market volatility had encouraged investors to overlook rising political risk in some countries, he added, while some fund managers were increasingly buying EM corporate bonds, which are less impacted than government bonds by sovereign ratings.
Simon Quijano-Evans, emerging markets strategist at Legal & General Investment Management, argued that, despite the deterioration in emerging market sovereign ratings this year, some traditional developed market investors “are gradually warming to the fact that the ratings differential between EM and DM has fallen over the years, [partly] because of the deterioration of DM ratings”.
Irrespective of the changes in sovereign rating dynamics, Quijano-Evans said three other factors had propelled flows into EM bonds this year. Firstly, despite the Federal Reserve raising policy rates four times since November 2016, US Treasury yields had failed to pick up to the levels that markets had anticipated, meaning the hunt for yield in EM hard currency bonds intensified. Secondly, developed market pension funds “face the need to buy into longer duration bonds in order to lock in returns”, aiding single-B rated sovereigns such as Nigeria and Argentina, which were able to issue 30-year dollar bonds for the first time, with the latter even getting a 100-year issue away. Lastly, Quijano-Evans argued the “investability” of EM assets in general was buoyed by the fact that debt ratios are far lower in the emerging world, with the IMF predicting an EM-wide public sector debt/GDP ratio of 50 per cent next year, against 106 per cent in the developed world.
STEVE JOHNSON, FT
