US, Sep 28 : Emerging market bond investors are becoming more cautious as a sharp rise in US Treasury yields puts pressure on valuations and raises concerns about the durability of gains in developing world debt.
Dollar denominated emerging-market bonds have delivered a 1.4 per cent return over the past year despite the recent turbulence in global credit markets. However, yields on US Treasuries have climbed to their highest level in almost two decades, while oil prices remain above $100 a barrel and investors prepare for a prolonged period of elevated global interest rates.
The spread between emerging market dollar bonds and US Treasuries has narrowed to about 170 basis points, its lowest level since 2007, according to JPMorgan data. Fund managers say such tight spreads leave limited room for further gains and increase the potential impact of another rise in global borrowing costs.
Jeff Grills, head of emerging-market debt at Aegon USA Investment Management, said attractive opportunities were becoming harder to identify. The firm has recently reduced its exposure to Colombia while increasing holdings in relatively higher-rated borrowers such as Indonesia, Saudi Arabia and the Philippines.
Other asset managers are also reducing exposure to riskier sovereign debt. Neuberger Berman’s Gorky Urquieta has cut positions in high-yield bonds issued by Ecuador, the Dominican Republic and Zambia, citing the challenging environment for adding risk to portfolios.
The shift follows a period in which emerging-market debt remained relatively resilient despite significant changes in expectations for global interest rates and heightened geopolitical tensions in the Middle East.
Persistent inflation and strength in the US economy have contributed to higher Treasury yields as markets reassess the outlook for Federal Reserve monetary policy. Despite these pressures, emerging-market dollar bonds have continued to retain much of their earlier gains.
Bloomberg Intelligence has identified US monetary policy as a key risk for hard-currency emerging-market debt in the fourth quarter. Analysts have warned that historically narrow spreads could magnify the effect of any fresh increase in Treasury yields or deterioration in individual countries’ credit conditions.
Investor caution is also evident in fund flows. The largest exchange traded fund tracking emerging market hard currency bonds recorded one of its biggest single day withdrawals since March last week.
Rather than leaving emerging markets altogether, several fund managers are shifting toward stronger borrowers. At PPM America, Matt Graves has increased exposure to longer-duration debt from higher rated issuers such as Morocco while reducing positions in riskier markets, including Angola.
Some investors are also finding opportunities in investment grade bonds after the Treasury market’s selloff pushed yields higher. Fernando Grisales, senior portfolio manager at Schroders in New York, said he had added debt issued by Saudi Aramco and Mexico.
Meanwhile, JPMorgan Asset Management has reduced its portfolio’s vulnerability to a potential credit-market downturn and moved part of its risk allocation toward local currency bonds. Pierre-Yves Bareau, the firm’s head of emerging-market debt, has increased exposure to markets including Mexico, where he believes interest rate expectations may be overly aggressive.
Local-currency emerging market debt has gained 0.9 per cent on average this year. Strong domestic interest rates and elevated commodity prices have continued to support investor interest in countries such as Brazil and Colombia.
The changing allocation strategies indicate that investors remain engaged with emerging markets but are becoming more selective. Higher quality sovereign issuers and local currency assets are increasingly being favoured as rising US yields reduce the appeal of taking additional credit risk.