Gathering Momentum: Investors Move into Emerging Market Debt
- Judging by the flows, many European fixed income investors have put the woes of 2022 behind them and focused on emerging market debt as one area to take on some risk – they’ve purchased $950 million in EM debt ETFs through the first 26 days of the year.
- We see three main reasons why EM debt has seen so much attention: historically high yield, the potential for depreciation of the US dollar, and a turning policy cycle for several EM central banks. We believe these factors could continue to support EM debt in the coming months.
A Good Start to the Year
Emerging markets (EM) have started the year with a bang, as significant inflows have moved into both equities and bonds. After a terrible 2022, the fresh slate for taking risk coupled with the reopening of China has reinvigorated demand for risk assets, including EM.
For fixed income, the recovery in performance dates back to Q4 2022, with the Bloomberg EM Local Liquid Index returning 8.8% during the quarter.1 At that stage, investors still seemed cautious on EM debt and we saw little evidence that this better performance was backed by meaningful inflows. This can be seen in the investor flows section of the Bond Compass, where Q4 was marked by a distinct preference for lower-risk strategies (investment grade credit favoured versus high yield) and developed market bonds seeing inflows in their 90th percentile while EM debt remained unloved.
While there was undeniably caution around EM assets, the fixed income flows data from the Institute of International Finance suggests a more nuanced story was at play during 2022. The chart below shows the investor flows split into those going into China debt and those into the broader EM complex (ex China). It is clear that the invasion of Ukraine sparked a massive outflow from Chinese debt funds, with appetite failing to stabilise until Q4. Conversely, non-China debt seems to have benefitted from the China exodus with what looks like big switches out of China bonds into other markets in February and March.
The second half of the year saw Chinese bonds continue to suffer outflows as they became less appealing as a source of yield2 relative to either US Treasuries or other EM debt. So EM ex China strategies continued to enjoy inflows in H2, taking non-China debt flows to $108 billion for the year.
Emerging Market Debt Investor Flows in 2022
The Appeal of Emerging Market Debt
The net flows position for all EM debt totalled $37 billion for 2022. The flows analysis illustrates that, outside of China, sentiment in EM was not as downbeat as perhaps some of the headline flows numbers suggest. However, there is little ambiguity to the flows data that has been seen so far in 2023, with a wave of money being allocated to EM strategies. There has been a lot of focus on equity inflows but European fixed income investors have purchased of $950 million of EM debt ETFs during the first 26 days of January.
As we highlighted in the Bond Compass, EM local currency debt in particular has several relatively attractive attributes for bond investors.
- The yield is historically high with a yield to worst of more than 6% on the Bloomberg EM Local Currency Liquid Index. Coupon returns alone for 2022 were 4.8% so, even if the markets stay at similar levels for much of the year, EM debt strategies could still generate meaningful returns.
- We believe the USD has further to depreciate over the course of the year. While it has cheapened versus EM currencies, it continues to look expensive according to the State Street Global Advisors long-term model of USD value and therefore could continue its decline as the Fed rate cycle turns. This should help to support EM returns.
- The turn in the policy cycle has arrived for several EM central banks. There remains speculation that Banco Central do Brasil and the Hungarian central bank may ease policy in the not too distant future. The South Korean central bank signalled that it sees its rate hike cycle as being at an end and the South African Reserve Bank tightened policy only 25bp instead of the 50bp predicted by economists, a sign that rates may be close to the top.
So EM debt has already delivered a strong performance but we believe that there is more to come, with flows hinting that it is one of the favoured strategies for 2023.