Executive Summary

 
  • Fundamentals of Emerging Market economies are looking better which suggests that credit rating upgrades are likely for some, a positive for GEM bonds.
  • Emerging Market debt yields have risen to 10-year highs which provides sufficient buffer for any market volatility arising from geopolitical risks.
  • Improving credit quality and Fed rate cuts will trigger a reversal of funds flows from Developed to Emerging Markets. Even if a small portion of the USD6 trillion money market funds in the US flows to GEM bonds, it will be a big technical driver of performance.

Between March 2022 and July 2023, the US Federal Reserve (Fed) raised interest rates by 11 times to slow inflation before hitting the pause button in July 2023. Markets read it as a sign of peaking rates and rallied in the last quarter of 2023. Bonds in particular made a strong comeback; the 10-year Treasury yields fell 69 basis points.

That euphoria has worn off. Recent data showed US inflation remained sticky albeit easing gradually, keeping hopes alive of the Fed cutting rates in June. Meanwhile bonds have erased most of the gains made since December 2023; the 10-year Treasury yield has climbed back to 4.1%. Against the backdrop of higher for longer rates, bonds may be in for another bumpy ride.

That said, it is worth noting that some areas of fixed income have generated strong total returns (higher coupons plus capital gains) in the past year. Generally, the higher-risk bond segment benefited more than the investment grade segment.

Global Emerging Market (GEM) bonds, in particular, appeal for their strong total returns. In 2023, the JP Morgan EMBI Global Diversified Index1 which tracks the total returns for US dollar-denominated debt issued by Emerging Markets’ sovereigns and quasi-sovereign entities rose by 11.1% when other bond indices returned 9.1% at best. GEM bonds continue to have the potential to deliver double digit returns once the Fed starts easing. There are several reasons underpinning our investment thesis.

The unsynchronised rate cycles across regions

To contain inflation, countries in Latin America (LATAM) started their monetary tightening cycle in March 2021, a year earlier than the US. Rates rose to 11.25% in Chile and Mexico and 13.75% in Brazil, enhancing the coupon rates. By moving faster than the US, Chile and Brazil have been able to slow inflation which enabled their respective central banks to start easing from the second half of 2023. As rates were cut, capital gains boosted overall bond returns. Although the region’s fight against inflation is not over, rate cutting in LATAM should gather pace this year once the Fed eases. Moreover, central banks in the region would likely want to normalise rates after tightening aggressively in the past two years.

Fig 1: Real policy rates remain high in most places

Fig 1: Real policy rates remain high in most places

Source: Bloomberg, Barclays Research, November 2023. Refers to policy rates minus 12m ahead inflation expectations.

Over in Asia, inflation is also receding; as per IMF estimates, the average Asian inflation fell from 3.8% in 2022 to 2.6% in 2023. However inflationary pressures in the region were not as high to begin with and Asian central banks did not have to tighten as aggressively as some of their counterparts in other regions. In fact, the US Fed funds rate exceeded the average policy rate in Emerging Asia in the second half of 2023. Despite the benign inflation backdrop, Asian central banks are unlikely to start cutting before the Fed given that foreign currency stability is a key consideration for the Asian countries. Once the Fed starts easing, they will have more scope to cut. Meanwhile, Central and Eastern European, Middle Eastern and African (CEEMEA) countries did not hike as much and hence are not able to cut as inflation is still an issue.

Separately, it appears that markets have priced in rate cuts of 75 basis points cut in the US and 70 basis points in Europe for 2024. But there is still an opportunity to get good returns based on a 24-month view; the average rate cutting cycle in the US over a 24-month period is between 200-300 basis points. Given this historical perspective, adopting a longer-term horizon can result in greater rewards for bond investors.

Supportive fundamentals and technicals

Global growth, estimated at 3.1% in 2023, is projected to remain the same in 2024 before rising modestly to 3.2% in 2025. Developed Market economies are expected to see growth decline slightly to 1.5% in 2024 before rising in 2025, while Emerging Market economies are expected to experience stable and higher growth of 4.1% through 2024 and 2025.2 This growth differential as well as higher fiscal prudence this year suggests that credit rating upgrades are on the cards for some LATAM and CEEMEA countries – all of which are positive for GEM bonds.

Fig 2: Better upgrade/downgrade ratio

Fig 2: Better upgrade/downgrade ratio

Source: Eastspring Investments, Barclays Research, November 2023

Ultimately the improving credit quality story will trigger a reversal of funds flows from Developed to Emerging Markets. Once the central banks in Developed Markets cut rates, investors will likely move out of money market assets into other asset classes for better returns. Within the bond segment, GEM bonds will be best positioned to benefit from these flows. The size of the money market funds in the US today is approximately USD 6 trillion. Even if only a small portion flows to GEM bonds, it will be a big technical driver of performance.

Fig 3: Potential flow reversal will support GEM bonds

Fig 3: Potential flow reversal will support GEM bonds

Source: Eastspring Investments, Barclays Research, November 2023. These figures are forecasts.

High carry is a sufficient risk buffer

Emerging market yields have risen to 10-year highs post the COVID-induced pricing pressures, the Russia-Ukraine war, and defaults by some countries. Given the improving prospects, the current average yield of 7.9% provides sufficient buffer for any market volatility arising from geopolitical risks. A benign outcome for the ongoing wars in the Middle East and Europe would be a tailwind for GEM bonds.

Fig 4: Yield to maturity of EMBIGD index

Fig 4: Yield to maturity of EMBIGD index

Source:J.P. Morgan EMBI Global Diversified Index (EMBIGD) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities, Eastspring Investments, March 2024

Ample opportunities for active managers

Within the GEM bond universe, investors can access a range of opportunities in more than 70 countries with diversification across hard and local currency, sovereigns and corporates, sectors, credit quality and maturity. Investors are able to enjoy significant yield picks ups since the interest rate cycle differs across the EM regions.

Against the backdrop of a global rate cutting cycle, we believe that duration can also be an attractive play. Currently the GEM government bond index3 has an approximate duration of 7 years while the GEM corporate index4 has a much lower duration of 4 years. Locking in the higher yields today is a good strategy to benefit from the higher carry over a longer period.

Another attractive feature of GEM sovereign debt is the relative safety and liquidity of the asset class which provide investors the opportunity to participate on the upside. At the same time, the expected rating upgrades for some EM countries should add to overall returns. All in the prospects appear brighter for GEM bonds; with investors being paid higher than in the last 10 years to take on EM risks, now seems a good time to buy GEM bonds.

Interesting reads

Know more
Why an Emerging Markets ex China strategy still holds value

in insights

Why an Emerging Markets ex China strategy still holds value

13 Jun | Navin Hingorani

A value-driven EM ex China strategy tends to outperform in the long term.

Celebrating 3 years with GEM ex China strategy

in insights

Equity

Celebrating 3 years with GEM ex China strategy

10 Jun | Samuel Bentley

Eastspring Investment's Global Emerging Markets ex China Dynamic Strategy / Fund ...

India elections: Key reforms likely to continue amid coalition dynamics

in insights

India elections: Key reforms likely to continue amid coalition dynamics

06 Jun

Key reforms are likely to continue as India’s new government navigates coalition ...

Why sustainable supply chains matter for investors

in insights

Why sustainable supply chains matter for investors

15 May

Making supply chains more sustainable can be a game changer for companies.

New anchors reshaping supply chains: Opportunities for investors

in insights

New anchors reshaping supply chains: Opportunities for investors

14 May | Bill Maldonado

Our pulse survey of 150 senior executives across North America, Europe and Asia ...

Japan’s small and mid-caps: An overlooked opportunity

in insights

Japan’s small and mid-caps: An overlooked opportunity

17 Apr | Max Godwin

The pressure to improve balance sheets is growing in Japan; small and mid-cap stocks ...

China: Awaiting the catalysts

in insights

China: Awaiting the catalysts

10 Apr | Jingjing Weng

The worst of the Chinese economy appears to be behind us, but the road ahead remains bumpy.

Asia ex-Japan equities: Prospects for higher returns as corporates “value-up”

in insights

Asia ex-Japan equities: Prospects for higher returns as corporates “value-up”

04 Apr | Sundeep Bihani

Asian governments are asking companies to boost returns by improving profitability ...

Not out of the woods yet

in insights

Not out of the woods yet

27 Mar | Nupur Gupta

Our multi asset team is tactically bullish on risk assets given the strong growth data ...

Enhancing bond returns in an ESG-disrupted world

in insights

Fixed income

Enhancing bond returns in an ESG-disrupted world

07 Mar | Rong Ren Goh

ESG-focused bond portfolios can deliver superior risk-adjusted returns.

Sources:
1 Regions covered in index are Asia, Latin America and Central and Eastern Europe, Middle East and Africa (CEEMEA)
2 IMF, January 2024
3 EMBIG index
4 CEMBI index

The information and views expressed herein do not constitute an offer or solicitation to deal in shares of any securities or financial instruments and it is not intended for distribution or use by anyone or entity located in any jurisdiction where such distribution would be unlawful or prohibited. The information does not constitute investment advice or an offer to provide investment advisory or investment management service or the solicitation of an offer to provide investment advisory or investment management services in any jurisdiction in which an offer or solicitation would be unlawful under the securities laws of that jurisdiction.

Past performance and the predictions, projections, or forecasts on the economy, securities markets or the economic trends of the markets are not necessarily indicative of the future or likely performance of Eastspring Investments or any of the strategies managed by Eastspring Investments. An investment is subject to investment risks, including the possible loss of the principal amount invested. Where an investment is denominated in another currency, exchange rates may have an adverse effect on the value price or income of that investment. Furthermore, exposure to a single country market, specific portfolio composition or management techniques may potentially increase volatility.

Any securities mentioned are included for illustration purposes only. It should not be considered a recommendation to purchase or sell such securities. There is no assurance that any security discussed herein will remain in the portfolio at the time you receive this document or that security sold has not been repurchased.

The information provided herein is believed to be reliable at time of publication and based on matters as they exist as of the date of preparation of this report and not as of any future date. Eastspring Investments undertakes no (and disclaims any) obligation to update, modify or amend this document or to otherwise notify you in the event that any matter stated in the materials, or any opinion, projection, forecast or estimate set forth in the document, changes or subsequently becomes inaccurate. Eastspring Investments personnel may develop views and opinions that are not stated in the materials or that are contrary to the views and opinions stated in the materials at any time and from time to time as the result of a negative factor that comes to its attention in respect to an investment or for any other reason or for no reason. Eastspring Investments shall not and shall have no duty to notify you of any such views and opinions. This document is solely for information and does not have any regard to the specific investment objectives, financial or tax situation and the particular needs of any specific person who may receive this document.

Eastspring Investments Inc. (Eastspring US) primary activity is to provide certain marketing, sales servicing, and client support in the US on behalf of Eastspring Investment (Singapore) Limited (“Eastspring Singapore”). Eastspring Singapore is an affiliated investment management entity that is domiciled and registered under, among other regulatory bodies, the Monetary Authority of Singapore (MAS). Eastspring Singapore and Eastspring US are both registered with the US Securities and Exchange Commission as a registered investment adviser. Registration as an adviser does not imply a level of skill or training. Eastspring US seeks to identify and introduce to Eastspring Singapore potential institutional client prospects. Such prospects, once introduced, would contract directly with Eastspring Singapore for any investment management or advisory services. Additional information about Eastspring Singapore and Eastspring US is also is available on the SEC’s website at www.adviserinfo.sec. gov.

Certain information contained herein constitutes "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof, other variations thereof or comparable terminology. Such information is based on expectations, estimates and projections (and assumptions underlying such information) and cannot be relied upon as a guarantee of future performance. Due to various risks and uncertainties, actual events or results, or the actual performance of any fund may differ materially from those reflected or contemplated in such forward-looking statements.

Eastspring Investments companies (excluding JV companies) are ultimately wholly-owned / indirect subsidiaries / associate of Prudential plc of the United Kingdom. Eastspring Investments companies (including JV’s) and Prudential plc are not affiliated in any manner with Prudential Financial, Inc., a company whose principal place of business is in the United States of America.