2019 was a strong year for emerging market debt in hard currency. Globally, the asset class generated a return of more than 11%*, driven in particular by falling interest rates and narrowing credit spreads – in other words, the excess yield on the bonds fell relative to US Treasuries, etc. with subsequent capital gains for investors.
“The narrowing of credit spreads can generally be attributed to investors hunting for bonds with a higher return potential in the current low interest rate environment,” says senior portfolio manager Jacob Ellinge Nielsen. He is co-manager of the fund Danske Invest Emerging Market Debt, which invests in emerging market bonds issued in hard currency and in 2019 delivered a higher return than the market generally.
We have asked him to give his assessment of the prospects for the asset class in 2020, here just under a month into the new year:
“There are a number of key factors pointing in the right direction for emerging market debt this year,” says Jacob Ellinge Nielsen, who adds:
“First of all, we expect global growth in 2020 to be a notch higher than in 2019, and that is important, as emerging market bonds are generally sensitive to growth trends,” he explains.
Emerging markets to drive growth in 2020
True, Danske Bank expects growth to slow in the developed markets like the US and Europe this year, but we also expect that will be more than offset by a growth surge in many emerging markets – led by the major economies, such as Russia and Turkey together with Latin America, with Brazil and Mexico at the fore.
“This will help support the asset class, while increased trade between the emerging market countries has reduced their dependence on the US economy, says the senior portfolio manager.
A second positive factor is the central banks, which generally cut interest rates in 2019 – also in a great many emerging markets.
“And we expect that central banks will maintain their accommodative monetary policies in 2020 – not least because inflation is very modest. This will further support the economies and bonds in emerging markets,” says Jacob Ellinge Nielsen.
Key risk factors
Other positive factors, according to Jacob Ellinge Nielsen, include the outlook for a minor increase in credit quality for a number of emerging markets as growth picks up, as well as the still low or even negative interest rates in many developed markets, which could prompt a further influx of new capital into emerging market bonds.
On the other hand, the US-China trade war will remain an important risk factor. For while the two countries recently signed a partial deal, there is still a long way to go before the dispute is finally settled.
“That being said, this is an election year in the US, and Donald Trump will probably be focused on keeping US voters financially secure. Hence, we essentially do not expect any further escalation in the trade war. Another and very topical uncertainty factor is the new corona virus, which could have a negative impact on economic activity, particularly in Asia, says Jacob Ellinge Nielsen.
While the overall picture looks set to be positive for emerging market debt in hard currency, according to the senior portfolio manager, he does not particularly expect a repeat of the high returns seen in 2019.
“Much optimism has already been priced into the bonds, so I would describe us at Danske Bank as cautious optimists in terms of return potential this year,” he says.
Emerging market bonds comprise an important component in Danske Bank’s portfolio solutions, as they help diversify risk and lift the expected risk-adjusted return. We currently have an overweight of emerging market debt in hard currency in our portfolios – in other words, a larger share than we expect to have in the long term.
*Data for index JP Morgan EMBI Global Diversified hedged in EUR. Over the past 5 years the index has given the following returns: 2015: 0.74%, 2016: 8.32%, 2017: 8.21%, 2018: -7.04%, 2019: 11.66%. Historical return is not a reliable indicator for future return.
Fund with a focus on emerging market debt
- Jacob Ellinge Nielsen is co-manager of the fund Danske Invest Emerging Market Debt, which invests in emerging market bonds issued in hard currency, such as the US dollar or euro.
- The majority of the investments are in government bonds.
- All in all, the fund invests in bonds from more than 75 countries.
- Bonds from countries such as Ecuador, Rumania, Mongolia, Ivory Coast and Costa Rica are currently among the most important positions in the portfolio.
- The fund is actively managed.
- FX risk is hedged.
- Read more about the fund here.
Two types of bonds with each their risks
Emerging market bonds can be issued in both local and hard currency, and from an investor’s perspective there is a considerable difference:
With bonds in hard currency the FX risk is limited, as investors receive their payments in hard currencies like the US dollar or euro, which can be also be relatively cheaply hedged against, for example, the Danish krone (DKK). On the other hand, there is a credit risk in terms of whether the countries can comply with their payment obligations.
With bonds in local currency there is in principle no credit risk, as the countries can always issue more money in their own currency to pay their debts. However, investors assume a substantial currency risk, where declining local exchange rates can erode returns for international investors and at worst give major losses.
Bonds in local currency are normally considered the more risky due to the potentially significant volatility in exchange rates.
Danske Bank has prepared this material for information purposes only, and it does not constitute investment advice. Always speak to an advisor if you are considering making an investment based on this material to establish whether a particular investment suits your investment profile, including your risk appetite, investment horizon and ability to absorb a loss.