The debate about when the Federal Reserve will start scaling back bond purchases is driving some investors to emerging-market assets less exposed to a potential surge in US yields.
William Blair Investment Management and Fidelity International are bulking up on high-yield or frontier bonds that are less sensitive to US interest rates. Meantime, Bank of America Corp is recommending that investors scoop up emerging-market euro-denominated bonds, predicting yields in the common currency will remain stable even when the Fed unveils plans to scale back its bond-buying campaign, probably in September.
Those moves are driven by memories of the 2013 “taper tantrum,” when developing-nation currencies and debt slumped for about six weeks as the dollar and US rates rise in response to the Fed’s surprise suggestion that it would reduce debt purchases. Jobs data showed robust growth, signalling the US recovery is on track. The question remains as to when the Fed will deem the rebound strong enough to start withdrawing stimulus.
“A taper tantrum that leads to a spike in US rates would start attracting investors out of most other asset classes, including emerging-market assets, into the US,” said Randy Kroszner, an economics professor at the University of Chicago Both School of Business and a former member of the Fed’s Board of Governors. “That would be a time of flight to relative quality. That would be time when people move into relatively safer emerging-market assets and pull out of relatively riskier ones.”
Of course, a selloff may not be anywhere near the magnitude seen in 2013 because developing nations have better buffers today, including stronger current-account balances and positive real yields. Improving growth expectations will also support equities and some currencies. Still, investors remain concerned about a potential hawkish surprise from the Fed in the coming months that could reverse capital flows into emerging markets.
“The emerging-market space will have to navigate around Fed communication on tapering,” said Eugenia Victorino, head of Asia strategy at Skandinaviska Enskilda Banken AB in Singapore. “Foreign positioning is also important. If there is a build-up in foreign positioning, the risk of a reversal in flows would have a more dramatic impact than if positioning had been light.”
Emerging-market bond funds attracted $3.4 billion of inflows in the four weeks through May 28, with equity funds drawing $6.6 billion,
according to Bloomberg’s calculations based on EPFR Global data.
South Korea’s KEB Hana Bank is planning a series of fixed-income calls starting Monday that may be followed by a dollar-denominated sustainability-bond offering. Cameroon and Slovakia are also seeking to sell debt this month.
Local-currency debt is often seen as the most susceptible to any rise in the dollar or US yields because either of those would reduce the carry return. A Bloomberg News study has identified that a 25-basis-point increase in yields in a month would be the tipping point for moves in higher-yielding currencies such as the Turkish lira, South African rand and Mexican peso.
Emily Weis, a macro strategist at State Street in Boston, recommends buying developing-nation equities. It’s a view shared by TS Lombard, which sees them as safer as they’re driven more by the dollar and US stocks than Treasuries.
During the 2013 taper tantrum, the 120-day correlation between MSCI Inc.’s emerging-market equity index and Bloomberg Barclays’s Treasuries gauge was less than 0.2. At the peak of this year’s global bond selloff, the stock gauge barely showed a link to US yields. That compares with correlations of about minus 0.6 with the Bloomberg Dollar Spot Index and 0.7 with the S&P 500.
Should the rise in US yields be moderate, emerging-market high-yield dollar debt may also prove popular. Junk debt has gained about 1% this year to outpace lower-yielding investment-grade securities as the 10-year Treasury rate climbed to around 1.6% from 0.9%. Frontier markets offer an even higher buffer against rising rates, with the bonds of the world’s least developed economies returning 3.9% this year.
That’s pushed Fidelity International toward local notes from Egypt, Ghana and Uganda as well as foreign-currency bonds from Argentina, Ecuador and Zambia, said Paul Greer, a money manager in London at the firm, which oversees about $700 billion. William Blair’s Marcelo Assalin sees US yields climbing toward 2% by year-end, boosting the appeal of junk debt.
Still, for others, determining the best place to ride out the tapering storm means examining how nations have fared during the pandemic. To do this, Eurizon SLJ Capital is looking at countries where demand for commodities and capital goods is stronger, said Alan Wilson, the firm’s portfolio manager.