Emerging Market Bond Investors Are Not Afraid Of Fed Rate Hikes 1

Contrary to conventional thought

With the US Federal Reserve expected to hike the federal funds rate 3-4 times this year, one would normally assume that emerging market assets would be out of favor with investors due to expectations of a stronger US dollar. However, as seen in the first article of this series, emerging market equities have done quite well this year.

The situation is similar for emerging market bonds. According to Bank of America Merrill Lynch data, dollar-denominated emerging market bonds have returned 2% this year. This is higher than 1.7% returned by US high-yield bonds and the flat performance by US high-grade bonds.

The graph above plots the spread between BofA Merrill Lynch Emerging Markets Corporate Plus Index and BofA Merrill Lynch US Corporate Master Index. The former “tracks the performance of US dollar (USD) and Euro denominated emerging markets non-sovereign debt publicly issued within the major domestic and Eurobond markets.” Meanwhile, the latter tracks US-issued corporate bonds.

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The decline in the graph shows that the spread between the emerging market bond index and the US corporate bond index has declined, indicating that investors are not demanding as high a yield on emerging market bonds as they were doing in the immediate aftermath of Donald Trump’s electoral victory in November 2016.

ETF flows remain strong

According to Bloomberg data, US-listed emerging market bond ETFs have attracted inflows amounting to $1.8 billion in YTD 2017 and $7.2 billion in the one year period until March 13.

The iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) has attracted the highest new inflows worth $1.08 billion in YTD 2017.

ETFs investing in local emerging market debt such as the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC), the WisdomTree Emerging Markets Local Debt Fund (ELD), and the iShares Emerging Markets Local Currency Bond ETF (LEMB) have done better than those invested in dollar-denominated emerging market bonds with returns of over 3.3% each.

However, ETFs invested in dollar and euro-denominated emerging market debt have not done badly either with the EMB having returned 2.2% this year. This is much higher than ETFs investing in US bonds like the iShares Floating Rate Bond ETF (FLOT) (0.4%), the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) (0.7%) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) (-0.8%).

Chasing yield

While an argument can be made that investors are just looking for higher yield and thus piling up emerging market debt, doing so for dollar-denominated bonds at a time when a rate hike in the US seems a near certainty may be indicating something else.

The first takeaway is that investment vehicles investing into emerging market bonds are usually quite diversified. They invest across a variety of countries, thus spreading out risk to some degree. And with more countries qualifying as emerging markets than 10 years ago, the risk is spread out even more.

But another more profound takeaway could be that investors are looking beyond the general trend that has persisted so far and looking into country-specific fundamentals of emerging market countries, which have evolved compared to a decade ago. If this is the case, some emerging markets may shed the tag of extreme vulnerability when it comes to policy changes in the US, thus making them more investible going forward.

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