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Continuing to Ride the Emerging Market Debt Bounce-Back
Emerging market debt was one of our investment themes in the Q2 Bond Compass, as we saw scope for a bounce in risk assets as the crisis receded. The Bloomberg Barclays EM Local Currency Liquid Government Bond Index has returned 9.45% since the end of March 2020 in USD unhedged terms.1
Despite this strong bounce, less developed markets have struggled to completely shake off the pandemic. High COVID-19 infection rates in countries such as Brazil continue to cast a shadow over the wider asset class. Nevertheless, emerging markets are diverse and, while some continue to suffer, others have been more effective at containing the outbreak. Indeed, it is this diversity that makes emerging market debt local currency an investment theme for the longer run. We see three key drivers:
Yields: Yields are relatively attractive in an otherwise lower-for-longer yield environment. Returns solely accounted for by coupons were 2.38% in H1 2020 for the Bloomberg Barclays EM Local Currency Liquid Government Bond Index. The index now has a yield to worst of 3.67% (as of 15 July 2020), low by historical standards but considerably higher than anything available in developed markets outside of high yield bonds.
Positioning: Investors are still underweight emerging market debt based on State Street Global Markets data released in our upcoming Q3 Bond Compass. Uncertainties around the resurgence of COVID-19 and wider geopolitical issues have left investor holdings in the 22nd percentile at the end Q2 2020, up from the 15th percentile at the end of Q1 2020. As investors look for yield, this long-term underweight may gradually be reduced if markets remain stable and a recovery emerges more solidly.
Currency valuations: With yields lower, future returns are expected to be led by a rebound in currency. There have been some signs of recovery but the currency basket for the Bloomberg Barclays EM Local Currency Liquid Government Bond Index was over 7.5% undervalued versus the USD, according to calculations from State Street Global Advisors at the end of June 2020.
Focusing on stability and diversification: Looking for the Asian skew
The Bloomberg Barclays EM Local Currency Liquid Government Bond Index has performed well year to date, driven by the high allocations to Asian bonds. This is the only region to generate positive performance, lifted by strong gains from the Philippines, as the central bank there has slashed rates. Moreover, we know that several of the larger countries within this Asian exposure, notably South Korea and China, have been more effective at dealing with COVID-19.
The higher allocation to Asia in the index, relative to other index families (c. 48% versus c. 30% in the JP Morgan EM GBI indices), means a lower exposure to the Americas, where some of the worst performers have been and the pandemic looks harder to control, notably in Brazil. Lastly, exposure to Africa and the Middle East is split between South Africa and Israel. This diversifies away some of the drag from South Africa. So while emerging market debt remains a risk asset, the Bloomberg Barclays EM Local Currency Liquid Government Bond Index has been effective at reducing exposure to some of the poorest performers.
Figure 1: Rebased index performance in EUR vs. EUR-USD evolution
How to play this theme
Investors can play the emerging market debt theme described above with SPDR ETFs. To learn more about the funds, and to view full performance history, please follow the links below:
Sources: Bloomberg Finance L.P., for the period 9-16 July 2020. Flows are as of date indicated and should not be relied upon as current thereafter.
1 Source: Bloomberg Finance L.P., as of 15 July 2020.
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