As the hunt for yield intensifies, investors are now piling into emerging market bonds as they look under every rock to try and the best returns on the global financial market.
According to the Financial Times, which cites data from EPFR, a widely followed tracker of mutual funds, investors are now pouring money into emerging market bonds at a record pace. The last two weeks saw record flows to emerging market bond funds. What’s more, data from the Institute of International Finance shows that last week cross-border flows into emerging market stocks and bonds hit the highest level since 2013.
Emerging market governments have only been too happy to help meet rising investor demand as bond yields for developed countries plunge to the lowest levels on record. According to date from Dealogic, foreign currency bond issuance by sovereign and local governments surged to its highest level this year in recent weeks as investors clamoured to get their hands on high-yield securities.
There are over $12 trillion of developed market bonds trading with negative yields at present, and it doesn’t look as if there’s going to be a significant reversal of this trend anytime soon. These abnormal conditions in the developed world bond markets are forcing investors into emerging market debt. CLSA analyst Christopher Wood believe that such a trade makes a lot of sense as, “a premium should be paid for those government bond markets where monetary policy is still orthodox”. He goes on, “this, in turn, will create a following wind for emerging market equities in the form of declining bond yields and strengthening currencies.”
To some extent, this wind is already shaping emerging market economics. The JPMorgan EMBI+ sovereign bond yields decline from a recent high of 6.72% to 5.27% while the JP Morgan Emerging Markets Currency Index, a benchmark for emerging market currencies against the US dollar, has risen by 8% since bottoming in January.
Emerging market bonds are the hot new trade but…
As long as emerging market central banks maintain their credibility and continue with an orthodox monetary policy, this emerging market bond buying should continue. However, if central banks in the developed world start to lose their credibility emerging market debt will be caught in a sudden global sell-off, which could cause a lot of problems for investors and national economies.
The US Treasury market is the most liquid market in the world, which means it’s the go-to choice for fixed income investors and traders. Emerging debt markets are nowhere near as liquid, and most investors are investing in the market via ETFs and global emerging market bond funds.
According to EPFR Global, net assets in global emerging market bond funds and ETF’s totaled $401 billion at the end of June. Emerging market fixed income ETFs have seen inflows of $8.3 billion this year, more than two-and-half times the amount of inflows in the same period last year.
If (or when) all of these investors run for the exit at the same time thanks to one catalyst there’s unlikely to be enough liquidity to maintain an orderly market. The ratio of corporate bonds owned by US mutual funds and ETFs, relative to brokers and dealers has surged from 1.7 times in 2007 to 31 times today. This ratio is only likely to deteriorate as more investors pile into emerging market debt.
All in all, emerging market debt may look attractive now, but investors need to be aware of what they are letting themselves in for if central bank credibility deteriorates there is a broad-based sell-off across global financial markets.