Only a year after talk of a reduction in monetary stimulus in the US sent emerging market bonds into a tailspin, the asset class has staged an impressive recovery - and investors are betting that spreads will continue to grind tighter. Emerging markets sovereigns tracked by J.P. Morgan's EMBI Global Diversified index have gained 7% so far this year, while corporates included in the CEMBI Broad Diversified index have returned 4.5%.
A strong technical bid underpinned by expectations of still accommodative monetary policy in the US and the potential for fresh stimulus in the eurozone has helped to drive a rally across global bond markets. Yet with emerging market credits still trading at a generous premium over similarly rated bonds in developed economies, investors are confident that the rally - especially among corporates - has further to go.
According to Scott McKee, a portfolio manager at J.P. Morgan Asset Management, investment-grade corporates in EM are trading at a spread of around 130bp over US peers, compared with levels as tight as 70bp-75bp in early 2012. "Emerging market corporates have hit the bottom of the credit cycle," he said. "If you look at leverage and coverage ratios, they hit their weakest point some 12 or 15 months ago. From a fundamental perspective, it is a fairly positive story."
A slowdown in primary issuance compared with last year has also helped to push bonds higher in the secondary. Emerging market borrowers have raised a combined US $216bn on the international markets year to date, according to Thomson Reuters data, compared with US $242bn over the same period in 2013.
A lack of inventory among dealers and relatively less robust primary supply has improved the technicals for secondary prices and the EM borrowers that wish to raise money at what are still low yields. Threats to the asset class remain, however. Most investors believe a sudden move in interest rates in the US is the largest risk the asset class faces this year. It would only take several days of rate volatility to unsettle some of the more flighty crossover accounts and send prices tumbling, in what remains a very illiquid secondary market, some observers say.
But expectations of a rate hike have been gradually pushed back, with most analysts now expecting the yield on 10-year Treasuries to remain below 3% for most of this year. Another worry is how EM corporates will be able to service their debt, especially against a backdrop of slow economic growth, lower Ebitda margins, and tighter domestic credit conditions.
"The rise in leverage has been concerning if you look at EM corporates that are not included in the CEMBI (index)," said Vanessa Barrett, chief EM credit strategist at Morgan Stanley. "Traditional lending to private companies has increased and there are risks of deterioration in banks' balance sheets." Barrett points out that, with the exception of Central and Eastern Europe, there is little evidence of a broadly based pick-up in exports and growth across emerging markets. While conceding that corporate earnings and economic growth have on occasion disappointed, others maintain a more sanguine view and point to sizeable cash buffers as a source of stability for EM corporates.
"In Latin America you talk to treasurers who have lived through triple-digit inflation," said Jack Deino, co-head of emerging market debt at Invesco. "They know economic growth comes and goes, but many have built sizeable cash positions because they know that liquidity can evaporate quickly." In primary markets, investors appear to have become more selective, as seen in the lukewarm reception received this week by deals from Caribbean-focused Trinidad Cement and Nigeria's Diamond Bank. But overall the positive tone is expected to help new issues. While many sovereign borrowers tapped the market early in the year, from an absolute yield basis they stand to benefit the most from the current environment.
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