Too cheap to ignore, EM dollar bonds take off with the Fed

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(Bloomberg) — Emerging market dollar bonds are starting to look like a bargain.

The incremental yield offered by developing country sovereign debt relative to US Treasuries topped 500 basis points, crossing a threshold crossed only two other times in more than a decade. This is prompting fund managers, including FIM Partners and Vontobel Asset Management, to bet that spreads will fall quickly, just as they have after previous spikes.

As the Federal Reserve prepares to raise interest rates this week, investors are looking for assets that can outperform amid tighter monetary conditions and a strong dollar. Emerging market bonds denominated in US currency seem to do the trick and have a history of rallying on Fed hikes. While a worsening of the war in Ukraine – or the fallout from a Russian debt default that is possible as early as Wednesday – could further derail this trade, fear of missing the market bottom has investors charging selectively titles.

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“Emerging market spreads have never ended a calendar year with a negative return when they started above 300 basis points,” said Francesc Balcells, investment director of emerging market debt at FIM Partners. . “There’s a lot of negativity in the price of debt right now.”

A JPMorgan Chase & Co. measure of the sovereign risk premium in emerging countries reached 526 basis points on March 8. This is more than the 507 basis points reached after the Fed rate hike in 2015 and the 468 basis points reached in 2011 after the US rate hike. the credit rating was downgraded. On both occasions, a bond rally ensued, narrowing the spread on developing debt to around 250 basis points. A surge during the Covid-related rout of March 2020 was also followed by gains within weeks.

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FIM Partners has started buying debt issued by Gulf and Latin American countries and is interested in beat high yield stocks like Oman. The asset manager will also invest in new debt offerings from Bahrain and Colombia, which are rated junk, and which “will come with big concessions” on their existing debt, Balcells said.

Adding to the bullish sentiment, history suggests that emerging market dollar debt tends to rally once Fed hikes are underway, as it offers investors a way to hold higher-yielding assets without local currency risk.

“A tightening in emerging market hard currency spreads is likely once the Fed starts to hike, as has happened in the last three bull cycles,” said Carlos de Sousa, fund manager at Vontobel.

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Selective bets

But cheapness alone is not enough to keep investors interested in emerging market assets, especially when a raging war threatens to boost inflation and dent global growth.

Dollar bonds suffered an annual loss in 2013 when the taper tantrum triggered capital flight and when the 2018 trade dispute between the United States and China hurt demand for risky assets. This year, emerging markets face both Fed tightening and a geopolitical flare-up.

“If Ukraine is somehow resolved, the Fed can come back to the fore,” said Guido Chamorro, co-head of emerging market hard currency debt at Pictet Asset Management. . “In this scenario, the first or second rise could signal a good entry point for emerging markets.”

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In the meantime, fund managers diving back into the asset class have become selective, favoring longer-maturity bonds that are less sensitive to rising rates or the debt of countries benefiting from the commodity boom.

De Sousa de Vontobel prefers Ecuador because crude prices around $110 a barrel reduce the country’s need to tap foreign capital markets. The Bank of Singapore advises its clients to buy 30-year bonds and sovereigns that are net exporters of energy and commodities, according to Todd Schubert, its head of fixed income research.

Yet for Avenue Asset Management, which has begun buying debt in the single B credit rating category, the potential rewards are worth the overall risk.

“Emerging market dollar bonds look quite attractive at the moment,” said Carl Wong, the firm’s head of fixed income.

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Here’s what to watch in emerging markets this week:

Russia is due to make a $117 million coupon payment on dollar bonds on Wednesday, as a default triggers a potential wave of defaults; the central bank is also expected to leave its key rate unchanged this week. China’s activity data will provide a boost to the trajectory of the economy in early 2022, with output growth expected to pick up in the first two months. months of the yearBrazil’s central bank is expected to deliver on its promise of a slower rate hike on Wednesday and policymakers could adjust their tone of communication depending on the impact of the oil price spike caused by war over country’s growth outlookTurkey likely to keep interest rates unchanged on ThursdayIn Chile, Q4 GDP growth will add evidence of strong recovery in 2021 and show robust consumption, rising net exports and growing drop in investments

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