The upside of EM and corporate debt

Fear of Fed rate hikes, higher Treasury yields and a higher U.S. dollar battered emerging markets in 2018, according to Robert Abad, product specialist at Western Asset Management in Pasadena, Calif.

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Adding to this perfect storm was “headline noise around trade wars, tweets from the Trump administration bashing China or strategic allies, [and] election risks in Mexico and Brazil—typically markets where most investors have their exposure,” he said in a Feb. 13 interview.

As a result, investors fled emerging markets en masse. But the tide may be turning for fixed income investors.

“Looking ahead, we think the outlook for emerging markets still remains positive,” said Abad, whose firm manages the Renaissance Multi-Sector Fixed Income Private Pool. “We’re still seeing growth momentum across the major economies, inflation trends look stable, and central banks are looking to cut rates now, after pushing them higher last year to stabilize their currencies.”

Valuations across emerging markets are also attractive, he said. Index yield spreads between emerging and developed market debt are nearly as wide as in 2018 and 2016. “This makes no sense to us, as we’re not in a global crisis scenario by any stretch of the imagination,” he said.

Currency levels, meanwhile, are about 35% lower than five years ago, he said, and the real yield of EM debt versus the real yield of developed-market debt is near the widest it’s been in 15 years.

Looking to specific countries, Abad likes Brazil, India, Russia, Mexico and Indonesia. “The average yields there are around 8% [to] 8.5%. That’s compelling value.”

However, emerging markets aren’t immune to risks. And one ongoing risk is the slowdown in China, said Abad, which could hurt global growth and affect risk assets like emerging market debt.

“What’s encouraging is the fact that China has taken some steps to shore up their economy. And that’s really a function of the increased tariffs that have come on and hurt the manufacturing sector in China over the last year,” Abad said.

“More recently, Chinese officials have initiated tax cuts, increased fiscal spending, [and] boosted lending to the private sector. These are all positives and, ultimately, this means the slowdown we’ve seen over the past quarter will probably reverse over the course of the next several quarters.”

Corporate bonds

Another investment vehicle that could see a turn is investment-grade and high-yield corporate bonds.

“We’re close to the end of the current [rate-hiking] cycle, which bodes well for the asset class,” said Abad. “These are sectors that were impacted over the fourth quarter of last year, but they’ve also stormed back like emerging markets.”

And while many investors were selling off in December, Abad took the opportunity to add exposure, which he said benefitted him in the new year.

“We didn’t buy into the market narrative of deteriorating fundamentals or increasing defaults just because there were some select problems in names like GE—very high-profile corporates,” he said.

A couple of areas he likes in corporate credit include short-dated callable and European high-yield bonds, which he said “will be refinanced over the next few years.”

He also likes European financials, where current valuations don’t reflect “fundamental improvements” to balance sheets, he said.

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