The first quarter proved challenging for EM debt, mainly due to soaring US Treasury yields and a bounce in the USD, which forced less committed investors to sell. Market conditions in Q2 have so far looked more benign as the USD and Treasury yields have drifted lower. Investor appetite for risk assets seems undimmed and this more favourable backdrop for EM debt, coupled with the relatively high yields on offer, may see investors returning to the asset class.
Q1 2021 was a turbulent period for emerging market debt (EMD). The asset class suffered from the pincer movement of rising COVID cases, which hit EMs and dented confidence in local assets, and a rebounding USD, driven by higher US Treasury yields. These factors put downward pressure on local currencies and EM bonds, driving total returns negative (see Figure 1). After eight months of recovering from the March 2020 crisis, this renewed weakness was a blow to investors with flow data suggesting meaningful outflows in Q1 2021 (see the Q2 2021 Bond Compass ).
Figure 1: Q1 Returns by Country for the Bloomberg Barclays EM Local Currency Liquid Govt Index
Source: Bloomberg Finance L.P., as of 31 March 2021. Past performance is not a guarantee of future results.
The flow data also indicates that holdings of EMD remain relatively high, which suggests investors have not yet deserted the asset class but have trimmed positions. Retaining an allocation to EMD looks sensible given the diversification benefits it offers, but also because several of the Q1 headwinds seem to be abating.
For local currency funds, the key drag on performance in 2020 was currency weakness. The Bloomberg Barclays EM Local Currency Liquid Index registered negative returns of 4.8% in 2020 due to currency declines, against a positive bond price return of 2.7% and a coupon return of 5.4%. This currency drag continued into 2021 with forex returns of -3.6% during Q1 (see Figure 1). However, after a quarter of USD strength, the trade-weighted index (DXY) again looks expensive and has started to slide.1
US Treasury yields may have plateaued, at least for the near term. In addition to the fact that stable-to-lower yields mean less support for the USD, in our note Shelter from the Storm: Where to Go Amid Rising Yields we demonstrated how an aggressive Treasury sell-off can have a negative impact on local currency EMD in particular. However, a modest rise in yields need not be damaging. Figure 2 shows the impact that changes in the 10-year Treasury yield have had on returns from the Bloomberg Barclays EM Local Currency Liquid Index over the past 12 months. There was a period when sharply rising Treasury yields pushed returns negative but, for most of the year, returns have been positive regardless of whether yields have been rising or falling.
A component of the positive performance in Q4 2020 from EMD was the result of market participants increasing their risk appetite. The institutional flows chart in the Q2 Bond Compass suggests that there were fairly heavy outflows from EMD during Q1 despite the persistence of the wider risk-on mood. If markets remain stable, investors could continue to accumulate risk assets but, with a lot of positive news already priced in for many risk assets2, the argument to look at areas such as EMD, which have not rebounded, should become more compelling.
The correction higher in yields also makes EMD more interesting as a yield harvesting strategy. This is particularly evident in the local currency debt market, where the yield to worst on the Bloomberg Barclays EM Local Currency Liquid Government Index has risen from around 3.60%, at the end of 2020, to 4.25%.
Figure 2: EM Local Currency Debt Returns vs. 10Y Yield Changes
Source: Bloomberg Finance L.P., as of 28 April 2021. EM local currency weekly returns over the past 12 months are derived from the Bloomberg Barclays EM Local Currency Liquid Index.
There are risks. EM economies have suffered terribly from COVID as the lack of access to vaccines and logistical problems in administering them have seen infections surge. The 20% allocation in the Bloomberg Barclays EM Local Currency Liquid Index to China and South Korea, where cases have been low, provides some stability – but there are no guarantees. Even in places such as Chile, where a widespread vaccine program had been deployed, infection rates have risen again. These factors will weigh on EM growth in 2021 but may also encourage central banks to keep policy looser for longer, despite increasing inflation pressures.
In summary, Q1 proved challenging for EMD, mainly due to soaring US Treasury yields and a bounce in the USD, which forced less committed investors to sell. Market conditions in Q2 have so far looked far more benign as the USD and Treasury yields have drifted lower. Investor appetite for risk assets seems undimmed and this more favourable backdrop for EMD, coupled with the relatively high yields on offer, may see investors returning to the asset class.
1The USD is estimated by State Street Global Markets to be 5.7% overvalued relative to the basket of currencies that make up the Bloomberg Barclays Local Currency Index, as of 31 March 2021. 2For instance equities are at, or close to their highs and spreads for higher risk bonds such as High Yield are at the tight end of their historical range.
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