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Enhancing total returns with yields

The window for Emerging Markets bond performance is still open

03 May 2019

By Michel Vernier, Head of Fixed Income Strategy

Stable global economic growth and a more accommodative US Federal Reserve should continue to benefit emerging markets (EM) bonds, whose valuations seem currently more attractive relative to comparable developed market bonds resulting in enhanced yield opportunities.

However, investors should be selective due to the diversity of emerging markets which translates to different risk and return profiles as well as different valuations within the EM complex.

While Brazilian and Russian government and corporate bonds in aggregate trade closer to their five-year spread lows, Argentinean, Turkish or Mexican bond spreads are still trading wide for example.

This performance divergence between certain countries and sectors within the EM complex has led to opportunities though respective challenges and risks must be considered in the investment case.

EM bond markets

Below we highlight a brief overview of selected EM areas together with our view of where spreads adequately price the respective risks:

Brazil

Brazilian bonds on average have recovered since the election in October of the new president, Jair Bolsonaro, who promotes reforms to bring back economic growth after the deep recession back in 2015 and 2016.

Growth and asset prices are highly dependent on the success of the envisaged pension, privatisation and deregulation reforms.

As much as it is likely that pension reforms will be watered down and delayed, we believe Brazilian bonds should be supported by the recovery in growth and the reforms.

While spreads of the sovereign bonds are extremely tight, we see value in the corporate financial sector. The sector benefits from improved business sentiment, solid loan growth and higher capital levels while bonds pay an additional premium to the respective Brazilian sovereign bonds.

China

Chinese bonds were only recently included in the Bloomberg Aggregate Bond Indices

Chinese bonds were only recently included in the Bloomberg Aggregate Bond Indices and constitute the largest complex within the Bloomberg Barclays EM USD Aggregate Index. With a market value of over US$400bn it is larger than Brazil, Mexico and Argentina complex valuations together.

Trade tensions in particular will likely continue to weigh on China’s exports which is one of the key reasons for the reduction of the 2019 growth target to 6 – 6.5% by the National People’s congress in March.

A more accommodative central bank and announced value-added tax cuts, for example, show the willingness of the government to support domestic growth which shows signs of stabilisation.

Chinese bond spreads on average trade at very tight levels offering only a small yield premium, while more value can be found in the high yield property sector on a selective basis due to the higher risk.

India

The upcoming general elections, of which results are expected on 23 May, get by far the biggest attention at the moment. The market seems to favour the ruling Bharatiya Janata Party (BJP) party led by Narendra Modi with the expectation of further economical reforms.

Meanwhile, the Indian central bank has eased external borrowing regulations and its more dovish stance has already spurred loan and earnings growth for Indian banks recently.

This provides a better basis for further improvement of the banks’ asset quality which still suffers from relatively high non-performing loan ratios.

Indian oil refiners in the meantime should benefit from a rangebound trading oil price. Any potential populist measures in order to curb inflation and any potential spike in the oil price on the other hand may hurt the sector.

The general election has potential to provide further volatility but spreads compared to other Asian credits already look relatively high and offer entry points.

Turkey

The country suffers from generally low currency reserves which have been used to defend the Turkish lira in the global currency market in light of the large and growing current account deficit.

Before the election in March, populist measures were put into place to stop the slide in the lira and curb very high inflation. But this may only be temporary in nature.

Consensus growth is forecast at 0.2% for 2019 which together with the hard currency US dollar indebtedness bears risks for Turkish corporate issuers. The relatively low leverage, strong liquidity and dollar revenue streams have helped multinational companies in Turkey so far and support the respective bonds.

Turkish banks and specifically government-related banks enjoy the support of the government which recently announced more supportive measures. Banks have built high reserves to deal with the high proportion of non-performing loans and have increased their capital ratios in order to deal with any potential spike in non-performing loans.

The highly vulnerable currency and the economic challenges put the sector generally at risk for further spread volatility. Risk/reward seems balanced and any spread volatility may offer more opportunities.

Russia

Apart from the sanctions from foreign governments, the economy in Russia as well as the credit quality of the major issuers seems relatively healthy.

The Russian economy has shown resilience to the sanctions, growing 2.3% in 2018, mainly helped by exports.

Russia’s fiscal surplus of 2% of gross domestic product has led to growing foreign-exchange reserves while a higher oil price should further boost the surplus. Meanwhile, slowing fixed investments and lower growth in consumption, which could be further depressed by the recent VAT hike, point to a slowdown in 2019.

Russian government bond spreads are trading close to the 2018 lows (five-year credit default swaps now: 127 basis points) while renewed sanction risk could change the direction quite dramatically again.

Sanctions would most likely have a direct, or at least indirect, impact on the energy and mining sector as well as the bank sector, which make the respective bonds highly vulnerable for repricing.

spread divergence chart

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