Emerging market bonds will enter 2014 coming off a year in which they finished as the worst-performing major segment of the bond market. Is the worst is over for the asset class, or is more volatility is on the way in 2014?
The short answer: 2014 may not be as difficult as 2013, but temper your expectations nonetheless. While emerging market bonds continue to offer above-average yields on both a nominal and “real” – or inflation-adjusted basis – investors need to employ a large degree of caution when deciding whether to reach for the extra income given that emerging debt is sure to be volatile in the coming year.
Reasons for Caution in 2014
Five factors could act as headwinds to the emerging markets’ performance in 2014.
Fed Policy: The rate at which the U.S. Federal Reserve tapers its stimulative quantitative easing (QE) program is a major question mark in the year ahead. While expectations are already baked into the market that the Fed will wind up its QE policy before the end of 2014, faster-than-expected growth in the United States may speed up the process and lead to instability in the emerging markets. While the asset class is unlikely to perform as poorly in this scenario as it did when the idea of tapering first emerged in the spring of 2013, the removal of Fed support nonetheless means that the odds are against the kind of hefty, double-digit returns that emerging market bonds produced in 2009, 2010, and 2012.
Economic Growth: Emerging-market growth came in well below expectations in 2013, headlined by weak showings for the key BRIC (Brazil, Russia, India, and China) countries. If growth remains sluggish in the year ahead, emerging-market bonds are unlikely to offer substantial upside. By the same token, stronger-than-expected growth – if not accompanied by rising inflation – could provide much-need relief for the asset class.
Inflation: The potential for higher inflation may force a number of countries – including Brazil, Turkey, India, and Indonesia – to raise interest rates in 2014. At a time in which growth is already slow, monetary tightening would represent insult to injury for financial assets.
Rising Supply: As in any market, an increase in supply can contribute to lower prices. This could be an issue for the emerging markets in 2014. According to Barron’s, the investment firm Barclays is estimating that emerging governments could issue a record $94 billion in dollar-denominated bonds in 2014, which would eclipse the previous record set in 2012. Absent a corresponding increase in demand, this increased issuance may dampen performance.
Investor Risk Appetites: Finally, the potential for an increase in investors’ aversion to risk is always a threat for the emerging markets. However, the issue should be given greater weight in 2014 given that 2013 brought a steady increase in investor optimism – and heady gains for the world equity markets – behind improving growth in the world’s developed economies. This creates greater latitude for disappointment – a development that would be sure to weigh on the emerging debt markets.
What Kind of Returns Should Investors Expect in 2014?
The litany of potential risk factors presented above should be an important consideration for investors, but it isn’t meant to convey that the asset class is headed for a crash.
Emerging market bonds offer yields above domestic investment-grade bonds, which can continue to attract assets from yield-hungry investors. Further, they were one of the few areas in the financial markets to finish 2013 in negative territory, which may work in their favor in the year ahead given that few asset classes are offering a meaningful value. Emerging market yield spreads - or their yield advantage over U.S. Treasuries - rose during 2013, even as yield spreads on domestic corporate and high yield bonds declined. This means that - barring any negative surprises - the emerging markets could outperform in 2014 despite the litany of risk factors described above.
Not least, the potential headwinds are all well known – meaning that by mid-year investors may begin to look ahead to more favorable conditions in 2015 during the second half of the year.
It should also be noted that the JP Morgan EMBI+ Index has finished with a loss in four years prior to 2013: 1994 (-18.9%), 1998 (-14.4%), 2001 (-0.8%), and 2008 (-9.7%). Each time, the index rebounded to close with a robust gain in the following year: 26.8% (1995), 26.0% (1999), 14.2% (2002), and 26.0% (2009). See the emerging markets' year-by-year total returns here.
Still, investors need to be prepared for an environment of high volatility and lower potential returns than emerging market bonds have delivered in the past. While 2014 is unlikely to bring a bear market for emerging debt, the upside is also limited. The highest probability outcome is therefore a return in the neighborhood of 5-6%. Given the likelihood of increased volatility, however, it may pay to keep some powder dry to be ready to capitalize on any sell-off that may occur in the first half of the year.
Abother solution: consider actively managed funds rather than index-linked portfolios. Active managers have the latitude to take advantage of opportunities in corporates or move into shorter-term bonds, which would be less vulnerable to tapering concerns than longer-term issues. While active management doesn’t necessarily equate to outperformance, it can help limit the potential downside risk.
Are Emerging Corporate Bonds or Local Currency Debt a Viable Option?
Local-currency bonds may be more vulnerable to the potential risks than dollar-denominated debt, but corporates look like a potentially attractive option in 2014.
Local-currency debt has become a popular option in recent years, on the theory that the potential for long-term currency appreciation can add to bonds’ total return potential. At the same time, however, local-currency bonds are highly sensitive to global asset flows. This was evident during the severe downturn in emerging currencies from the beginning of May through the end of August, 2013. During that time, Wisdom Tree Emerging Markets Local Debt Fund (ELD) fell 8.9%, underperforming the -6.6% return of EMB. The potential for this type of underperformance remains in place for 2014, particularly among the “Fragile Five” economies (Brazil, Turkey, Indonesia, South Africa, and India).
Corporate bonds probably offer the best opportunity among the various segments of the asset class. Not only do they offer higher yields, which provides them with a more favorable starting point for total return, but they also tend to have a lower sensitivity to prevailing interest-rate movements – a positive if U.S. Treasury yields keep ticking higher. In addition, corporate issuers – as a group – are in robust financial health, with much better credit ratings than bonds with similar yields issued by companies in the United States. There’s no doubt emerging corporates can be hit hard in the short term if investors lose their appetite for risk, but over the full year the asset class looks poised for outperformance.
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Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.