Interest Rates on Bonds from Emerging Markets Are Currently Attractive
Emerging market local currency debt has underperformed as developed market bond yields have softened, leaving rate differentials at attractive levels given improved emerging market growth and external balance fundamentals.
European bonds and peripheral sovereigns in particular rallied strongly after the European Central Bank (ECB) meeting at the end of October. Despite the central bank’s ability to significantly support this fixed income segment and short-term momentum indicators suggesting further strength, we view Eurozone government bond yields as low and see a risk of repricing, particularly for Italian government bonds.
Fundamentally, we believe that credit and especially subordinated financial debt should be less subject to potential setbacks driven by a repricing of ECB policy normalization. We thus reiterate our long-standing preference for bank additional tier 1 and insurance subordinated bonds.
In non-financials, credit spreads are tight, with European high yield bond valuations having reached very unattractive levels. In our opinion, a mix of equity and leveraged loan exposure offers a better risk-reward profile at this stage of the business and central bank cycle. For EUR investment grade corporate investments, we consider rate risk to be significant and view credit derivative exposure as the best alternative given the supportive economic environment.
Focus on Long-Term Bonds from the Energy Sector
In USD, although strong economic momentum may continue to push short USD bond yields higher, weak inflation pressure should, in our view, keep longer yields in the current trading range. We thus prefer longer maturities in USD.
Next to attractively valued US inflation-linked bonds, we focus on investment grade corporate bonds and in particular on energy issuers that offer a decent yield. We avoid retail exposure. Elsewhere, we reiterate our cautious stance on the US securitized segment given that consumer loan fundamentals are showing further signs of weakness.
For yield enhancement, we favor emerging market local bonds to hard currency and high yield bonds.
Sylvie Golay Markovich, Head of Fixed Income Strategy
Emerging Market Bonds Offer Attractive Interest Rates
For yield enhancement, we favor emerging market (EM) local bonds to hard currency and high yield bonds. Following the recent repricing of EM rates and currencies, mainly due to idiosyncratic risk, the asset class has been lagging the decline in core rates.
However, valuations relative to the G10 countries have now moved to attractive levels in real terms and positioning in EM FX has lightened significantly following the correction. While political risk has recently risen in some high-profile EM countries like Turkey or South Africa, fundamental valuations reflect those risks adequately, in our view.
Emerging Markets Benefit from Economic Growth
More generally, in the absence of external shocks, we continue to see a favorable economic backdrop for the EM complex, with activity accelerating on stronger domestic demand. Structurally, EM economies also look less vulnerable to higher core rates than in 2013 during the Federal Reserve «taper tantrum» episode, when large external imbalances put pressure on EM asset prices.