Brighter prospects for active EM bond investors

27 Feb 2023

Active investing

Commentary by Nick Eisinger, emerging markets lead strategist, and Kunal Mehta, head of fixed income specialist team, Vanguard, Europe.

After a difficult 2022, we see brighter prospects ahead—and the seeds of new active opportunities—for investors in EM bond funds.
With the Fed likely nearing the end of its tightening cycle and EM growth rates expected to improve relative to G7 countries going forward, the backdrop is more constructive.
In our view, the best approach in this environment is to focus on bottom-up security selection and relative value.

Like many other fixed income sectors, emerging market (EM) sovereign bond markets endured a difficult 2022. Roiled by repeated interest rate rises by the US Federal Reserve (Fed), as well as the challenges of geopolitics and China’s zero-Covid-19 policy-induced slowdown, EM debt markets witnessed double-digit negative returns for the year¹.

But after last year’s rout, we see brighter prospects ahead—and the seeds of new active opportunities—for investors in EM bond funds.

A more constructive backdrop

With the Fed likely nearing the end of its tightening cycle, one of the stiffest headwinds for EM debt in 2022 is showing signs of easing. Our baseline outlook is for the US federal funds rate to reach a peak of between 5% and 5.25%² in 2023, and expectations of a less aggressive Fed are already attracting investor flows back into EM bond markets after they had flooded out of the asset class amid last year’s recurrent rate rises.

Add to that our belief that we’ll see another year of net negative bond supply in EM debt markets, and you have a potentially constructive supply-demand (or “technical”) backdrop supporting EM credit.

Economic growth expectations are also contributing to our positive outlook. We believe EM growth rates should broadly improve relative to G7 countries going forward³. We also anticipate an economic rebound in China⁴—one of the largest EM economies—as the country reopens following its zero-Covid-19 policy. In short, a stronger China is positive for EMs, especially for the prices of commodities, which typically represent a larger share of GDP for EMs relative to developed market peers.

Country fundamentals across EMs are broadly stable, though we expect significant credit differentiation as the global economy slows down in 2023. This is likely to open up relative-value opportunities for active management. As EM growth picks up, we particularly see opportunities emerging in EM local currency bonds— an area where we were much more cautious in 2022—and we continue to add exposure here.

Further, EM bond yields are at much more attractive levels than they were a year ago, offering a more compelling starting point⁵. Developed market government bond yields—the foundation upon which EM credit yields are built—have moved to high enough levels after 2022’s US Treasury sell-off to provide much more ballast to EM debt portfolios. This means that they should be more negatively correlated with risky assets after a prolonged period during which they had been positively correlated. This should boost investor interest in EM local currency bonds.

Risks remain

Despite the more promising outlook, there are risks that EM bond investors need to be aware of.

With the US economy weakening, we see a risk of it moving into recession later in 2023 or in 2024. As a result, we are more cautious on the outlook for certain parts of the EM high-yield market, which is usually more sensitive to US growth than the rest of EM debt markets – that said, some EM high-yield bonds are already pricing in the likelihood of recession. Here, a lot will depend on the timing and severity of a US recession.

Given this environment, we have been rotating out of high-yield credits into higher-quality, investment-grade EM bonds, although we retain some selective holdings in high-yield, where we think the pricing relative to the fundamentals are attractive – such as in Nigerian and Egyptian sovereign bonds.

In terms of monetary policy, while signs of peaking policy rates are undoubtedly positive for EMs, as central banks enact quantitative tightening, this will reduce liquidity in global debt markets. This is likely to be more impactful for riskier EM assets than more defensive, higher-quality credits.

What’s more, while EM bonds do offer compelling yields, they now face greater competition from other segments of fixed income, where yields have also risen – not least in ‘risk-free’ developed market government bonds⁶.

An abundance of active opportunities

In spite of the risks, EM bonds can be a valuable holding within investors’ fixed income credit allocations, having the potential to outperform most other fixed income sectors should global conditions improve.

EM credit asset prices have already started to reflect the more promising outlook, returning 8.1% during the fourth quarter of 2022⁷. While technical factors have already been supportive, we are yet to see the return of investor flows into the asset class after a very weak 2022. Should these flows return as we expect—and provided the Fed is able to engineer a ‘soft landing’—EM debt has the makings of a very solid performance year in 2023.

One of the key benefits of the EM bond asset class is that it is highly diversified, spanning different countries and sub-asset classes across government and corporate bonds issued in both hard and local currencies. This presents many opportunities for an active manager to generate alpha. We have observed significant dispersion across asset classes (that is, across EM local bonds, currencies and credit), credit curves and credit quality.

This can allow an active investor an abundance of chances to identify relative-value opportunities and benefit from mispricings between asset classes, credit qualities or even the shape of the credit yield curve. As a result of these plentiful opportunities, active EM debt managers should not be obliged to take outsized, directional bets—which can falter in more volatile environments—in order to generate significant alpha for their investors. In fact, we believe that getting directional—or “beta”—calls correct is likely to be even more challenging than in previous years.

In our view, the best approach is to focus on bottom-up security selection and relative value. This has always been at the heart of our approach to active fixed income, in all market environments.

Our active bond funds managed in-house

Vanguard Emerging Markets Bond Fund

Vanguard Global Credit Bond Fund

¹ Source: JP Morgan EMBI Global Diversified Index from 31 December 2021 to 30 September 2022 and to 31 December 2023. The index returned -17.8% for 2022, but had been down by as much as -24% year-to-date before a strong fourth-quarter rally pared back the losses.

² Source: Vanguard.

³ Source: Vanguard.

⁴ Source: Vanguard.

⁵ Source: JP Morgan EMBI Global Diversified Index as at 31 December 2023. The average yield of the index as at 31 December 2023 was 8.5%.

⁶ Source: Bloomberg US Treasury Total Return Unhedged USD as at 31 December 2022. The average yield of the Bloomberg US Treasury Total Return Unhedged USD index was 4.2% as at 31 December 2022.

⁷ Source: JP Morgan EMBI Global Diversified Index from 30 September 2022 to 31 December 2022.

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Brighter prospects for active EM bond investors

A more constructive backdrop

Risks remain

An abundance of active opportunities

Vanguard active fixed income

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