In a period of global growth, the $300bn emerging market debt sector looks set to gain popularity whi...
The global economy is being revitalised to the benefit of the export markets and therefore the foreign capital levels of less developed countries (LDCs).
Julian Adams, fund manager of the Aberdeen Sovereign High Yield fund, says: "The emerging markets' difficulties are behind us. There is a return to flexible exchange rates, while increasing trade and current account surpluses are making them less reliant on foreign capital."
The lowest risk of default comes from countries that are both willing and able to service debt. The ability to service dollar-denominated and euro-denominated debt relies on the economic strength of the country and the rate of foreign currency inflows.
Commodity prices are healthy in many areas, which has a positive effect on oil-rich countries such as Mexico. The cyclical upturn in global growth has increased the ability of developed countries to absorb LDC exports, improving the ability of LDCs to draw foreign currency.
While emerging market bond returns are strong, G7 bonds have suffered. US treasuries averaged a 5.2% income last year, while emerging markets bonds averaged around 12%. The spread between US treasury yields and emerging market bonds narrowed from 11,000 to 800 basis points but the difference in capital gain made up for this difference.
For US treasuries, sinking prices meant that last year their total return was -2.88% while the Emerging Markets Bond Index Plus rose 25.97%.
The fate of the market for the next year depends on how successful central banks are at keeping the temperature of the economy at a comfortable level.
Rupert Walker, emerging market bond fund manager for AIB Asset management, says: "There are three scenarios. First, the central bankers do the right things, there is no inflation and there is sustained global economic growth - great for emerging market bonds."
In the second scenario, the central banks are not so successful and world bond markets try to discount the risk of sharp economic changes. This will be bad for G7 bonds but the emerging market bonds will outperform, becoming more of a defensive bond instrument because of its high income.
The third possibility is the nightmare. Inflation goes out of control, causing Nasdaq and the S&P 500 to suffer. Emerging markets lose investor confidence and the supply of bonds will overwhelm demand, dragging the market down.
Walker thinks the second is the most likely scenario.
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