Volatility returned to many fixed income markets during May and June, particularly the emerging market debt ("EMD") market. Through the end of June, heightened volatility remained and performance across all EMD markets suffered. The recent sell-off has largely been driven by fears of a potential slow-down in asset purchases by the U.S. Federal Reserve, ongoing social unrest in Turkey and Brazil, a potential "cash crunch" in China, and mixed economic data both in the U.S. and abroad.
Many of the major emerging market debt indexes declined meaningfully during May and June. Local currency emerging market bonds were the worst performer of the group as the benchmark index was down 10.1% over the prior two months. This loss represents the fourth-worst two month stretch for the index since its inception in 2003, with the prior three periods occurring during the global financial crisis in 2008. EMD hard currency and corporate bonds also fell sharply during this time period. Beyond sovereign and corporate bonds, emerging market FX also declined but outperformed on a relative basis. Table 1 provides recent performance for each market.
Table 1: Performance of Emerging Market Debt Markets
The dismal performance over the last two months was driven by both rising U.S. Treasury yields and a widening of spreads. Spreads on the JPM EMBI-GD index widened 58 basis points from April 30th through June 30th. This widening in spreads along with a similar rise in Treasury yields caused the index to decline 8.3% over this two-month time period. Current spread levels on the hard currency index are at levels not seen since the summer of 2012 during the height of the European sovereign debt crisis. In the local currency bond space, the rise in interest rates was even more pronounced as yields climbed 128 basis points on the JPM GBI-EM index from April 30th through June 30th.
Prior to the downturn in May and June, assets flowing into emerging market bond strategies were strong. Even in spite of the sell-off, emerging market bond mutual funds recorded $7.7 billion in net inflows through the first five months of 2013. This followed on the heels of 2012 when mutual funds in this asset class gathered $22.0 billion in total net inflows. The cumulative impact of net inflows during the past 17 months led to total assets under management of $82.1 billion across all emerging market bond mutual funds. This level represented a peak for the asset class and a nearly 5x increase in assets since the beginning of 2010. At May 31st, AUM for emerging market bond mutual funds increased 10x since the start of 2005. Exchange traded funds (ETFs) tracking emerging market bonds experienced similar exponential growth as total ETF AUM was roughly $10.8 billion as of June 30, 2013. This compares to just $1.6 billion in AUM at the start of 2010. The recent sell-off did, however, trigger modest outflows from both mutual funds and exchange trade funds.
EMD markets have suffered through one of their worst two-month periods on record. The speed and magnitude of the declines experienced in these markets over the past several weeks have been on par with other periods of economic stress such as the 2011 European sovereign debt crisis, the 2008 global financial crisis and the 1998 Russian debt crisis. Prior to this recent downturn, Rocaton became concerned about the level of yields and spreads on emerging market bonds along with the massive amount of net inflows into the asset class. Although the recent decline has alleviated these concerns slightly, we are still cautious on the outlook for EMD over the next three to five years. Notably, the smaller decline in emerging market corporate bonds (which have historically fared worse than sovereign issues) is one signal that there are potentially more declines on the horizon. In our view, the less liquid bonds in emerging markets (i.e. corporates) have been slow to reprice, perhaps due to illiquidity, and are due for further correction. Further, the level of issuance in the corporate market has grown tremendously in just the last few years.
The heightened volatility and weakening fundamental backdrop may undermine short term returns for emerging market fixed income in both hard currency and local currency. For long-term investors in the asset class, we would not advocate wholesale changes to investors' exposure. For investors who have tended to focus purely on hard currency approaches to the asset class, it may make sense to consider broadening the opportunity set to incorporate a greater portion of local currency going forward. For investors with more flexible portfolios who can take advantage of long/short strategies or distressed investing strategies, for example, we feel that there may be attractive risk–adjusted opportunities created by the recent turmoil and change in outlook. Distressed EMD strategies seek to take advantage of market dislocations and macro or company-specific deterioration. These strategies may be packaged in private-equity style vehicles with multi-year lock-ups, but are better positioned to benefit from further declines in EMD markets.
Other alternative solutions include allocating to total-return oriented EMD strategies which do not attempt to beat a benchmark, but instead try to deliver positive absolute returns and make use of a wide opportunity set including the ability to short bonds and currencies.
Emerging market debt has been one of the best performing asset classes over the last decade and the fundamental case for an allocation remains. However, given the level of yields and strong asset class inflows, there is the potential for disappointing results over the near -term. As suggested above, there are several ways that investors can continue positioning their EMD allocation to optimize results.