Emerging market fixed income investors hope the taming of inflation, and the pivot towards rate cutting by central banks that would follow, will reverse what has been a year of near continuous outflows from their funds.
Outflows from EM bond funds totalled $86bn in 2022, as of the week ended November 4, according to JP Morgan. The Institute of International Finance, meanwhile, said outflows from EM bond and equity funds were $75bn to the same date.
Weekly outflows have become the norm, with consecutive weeks of inflows restricted to the summer, when many investors take a holiday. Recently, outflows have regularly been in the several billion a week.
It is important to note that EM debt is not alone in suffering high outflows during 2022. Investors have fled US Treasuries, sending yields soaring, and those yields have been volatile on top of the upward trend. On the 10 year Treasury, upon which EM dollar debt is priced, the yield had jumped to 3.9% by early November from 1.6% at the start of the year.
These rising US Treasury yields and day-to-day volatility are a core reason why clients have fled EM bond funds.
“Fixed income in general has been having significant outflows,” says Alexander Kozhemiakin, head of EM debt at Macquarie Asset Management in New York. “EM debt is not an exception. Flows are typically neither leading nor lagging performance.”
The year did begin with inflows. But these reversed after Russia’s invasion of Ukraine on February 24, which sent the prices of EM bonds tumbling. The worst week for outflows from EM debt and equity funds was the week ended March 11, at $22.9bn, according to the IIF.
Sanctions on Russian energy and the disruption of exports from Ukraine, particularly grain, led to global fuel and food inflation in many EM countries. Inflation is the enemy of fixed income investors and interest rate rises to combat it have made borrowing more expensive.
“We have seen that the aftermath of the invasion and important interest rate hikes by G3 monetary authorities contributed to the fear factor around flows,” says Jonathan Fortun Vargas, economist at the IIF. “The lack of an announcement of lifting [Covid-19] restrictions in China has also influenced and accelerated the outflows.”
Flight
Both retail and institutional investors have pulled their money out of EM bond funds, say EM fixed income portfolio managers. “Most negativity is due to duration and sensitivity to US Treasuries than spread performance,” says Kozhemiakin. “In US dollar EM debt, two-thirds of negative returns are due to duration and the rest to spread. It has been a duration-driven sell-off so far.”
Kaan Nazli, EM sovereign portfolio manager at Neuberger Berman in London, blames the Ukraine war, fear of sovereign defaults and inflation.
“Ukraine has caused lots of problems and stoked fears over China and Taiwan,” he says. “Sovereign defaults are pretty rare, and we had some understandable ones in 2020, but we have had more in 2022. They look bad and create worries over the whole asset class.
“And thirdly, inflation. Are we in a new inflationary environment? Turkey has printed a five year at 10% — is that sustainable? Only some EM countries can afford that in the long run.”
These high funding costs, which have shut many EM issuers out of the primary bond market in 2022, mean it will become difficult for them to service debts, adding to default risks. However, regaining access will lessen default risks and draw money back to EM bond funds.
“This is crucial as the option to roll debt over then becomes available and reduces the probability of default on external debt,” says Carl Shepherd, EM fixed income portfolio manager at Newton Investment Management in London.
The outflows have forced investors to keep high cash levels to protect against further outflows. They have money to invest in new bonds but are very selective about doing so.
Kozhemiakin says his fund has been at its maximum cash level, about 20%, for nearly a year. But that is changing.
“Over the past few weeks, we have started reducing our cash level but we are not necessarily buying the highest yielders that people would typically think of as ‘EM debt’,” he says. “We have been buying the more staid investment-grade EM debt.”
So who is left? Nazli at Neuberger Berman believes that “tourist” money — those investors who were invested in the asset class for the yield rather than any strategic reason — has left EM and so have many investors whose mandates permit them to invest in developed markets as well. This leaves dedicated EM investors — but international investors are not the only ones propping up EM debt.
“Local investors are becoming an important part of the asset class,” he says. “Look at Turkey, their Eurobonds have done quite well and one of the main reasons is regulations encouraging local buyers.
“We have seen that in Jordan too, and in South Africa there is a large local asset management industry providing support. Local investors have become a bigger part of the pie.”
Local investors can help mitigate default risk in EM, providing an alternative source of funding should an issuer be shut out of international markets.
“Many EM names have grimly held on so far despite the market stress and dislocation,” Shepherd says. “The currency mix changes over the last few decades, such as developing and deeper local markets in the major EM names, are also now proving their worth in reducing default risk and offering alternative sources of funding outside of global portfolio capital.”
Kozhemiakin says the investors left in EM debt are those there for the right reasons, and not just for the “optics” of higher yields.
“They want to take on additional country risk (outside of the ‘developed’ countries) for diversification reasons and are happy to be compensated for that risk,” he adds.
The fund managers and Fortun -Vargas agree that taming inflation will be crucial in stemming outflows and drawing money back to EM bond funds, but more is needed than just falling inflation numbers.
“A combination of stable and proved policies, capacity of policymakers to navigate future challenges, a sound and healthy local market and overall healthy macroeconomic variables will help a region or country to manage their level of flows,” says Fortun Vargas.
November 10’s US inflation print, which was below expectations, prompted a near 40bp rally in US Treasuries and raised hopes that inflation may have peaked, at least in the US. This could lead the US Federal Reserve to end its tightening earlier than predicted, and pivot towards cutting interest rates.
“We need a consensus on what terminal rates are likely to be for the US, and we need to move on from the US economy sucking in global dollar liquidity as the investment destination of choice, which should halt the rise of the dollar,” says Shepherd. “We now appear to be in a transition phase where it is no longer apparent that the dollar remains on an inexorable rising trajectory.”
GlobalCapital spoke to Nazli and Kozhemiakin before November’s inflation reading, and their outlooks for EM bonds next year were “cautiously optimistic” and “not bullish” respectively. Nazli cites Chile, where the central bank has been raising rates for longer than the Fed and inflation has started to turn.
“But it took a long time,” he says. “The jury is still out on whether the terminal rate in the US will be 5%. We also need a recovery outside of the US, which is outperforming economically the rest of the world. When that happens, it doesn’t help EM. You need growth in EM itself but also in the eurozone and China.”
Pain relief
Much of the pain in the EM bond markets in 2022 has been felt most acutely in longer maturities. However, Kozhemiakin thinks this pain could be coming to an end, which would give EM debt a boost. But beyond that, it is difficult to be optimistic.
“Next year [2023] will be better in one regard, that we are closer to the end of the US Treasury sell-off than the start,” he says.
“That will support fixed income in risky countries. We are getting close to the end of the duration-led sell-off. When the Fed gets closer to peak rates we will see more economic slowdown, and when inflation rolls over that will be good for duration.”
And Shepherd says that the EM bond market could well have reached a nadir, and it can only get better.
“With such sustained outflows from the asset class, the technical factors are about as low as they can be, so the potential for formerly unloved areas to turn around increases as time moves on,” he says. GC