Emerging market bonds resilient

EMERGING-market bonds could prove more resilient to renewed European debt turmoil, with stronger public finances, higher yields and more credible central banks offering investors a buffer against another bout of global market volatility.

However, as concerns over France’s borrowing costs revive memories of the eurozone debt crisis 15 years ago, investors may become more selective, favouring countries with sounder fiscal positions while keeping a close eye on economies vulnerable to rising financing costs.

As a Bloomberg report notes, emerging-market assets have so far shown greater resilience than they did during the previous European debt crisis, supported by improved economic fundamentals and central banks that have earned greater investor confidence through earlier periods of upheaval.

The renewed concern stems from the widening gap between French and German government bond yields, which recently reached its highest level since the regional debt crisis in 2011. Rising oil prices amid conflicts in the Middle East and Ukraine have added another layer of uncertainty to the global economic outlook.

Still, investors say emerging markets are better placed to weather the fallout than they were a decade-and-a-half ago.

“Compared to 2011, emerging markets are better positioned today, with stronger fiscal dynamics, external balances, and high nominal yields that provide structural resilience,” Carol Lye, a fund manager at Brandywine Global Investment Management in Singapore, tells Bloomberg.

She adds that relatively light positioning in emerging-market currencies could reduce the risk of forced selling if a renewed eurozone crisis triggers a broader retreat from riskier assets.

That assessment has encouraged Brandywine to increase its holdings of Latin American currencies while maintaining exposure to North Asian currencies benefiting from spending on artificial intelligence (AI).

The contrast with 2011 is significant. When the European debt crisis intensified in August that year, investors rushed towards safer assets, leaving emerging-market bonds and currencies exposed to sudden capital outflows, as Bloomberg highlights.

The additional yield investors demanded to hold emerging-market dollar bonds over US Treasuries subsequently climbed to as much as 447 basis points (bps) in October 2011. That level was exceeded only in 2020, at the height of the Covid-19 pandemic, the newswire points out.

Today, the premium stands at about 184 bps, suggesting that investors are demanding considerably less compensation for taking on emerging-market sovereign debt risk than during those previous periods of stress.

Market performance has also offered some reassurance. Despite 10-year US Treasury yields climbing above 5% last month, their highest level since 2002, the yield on a Bloomberg index tracking global emerging-market local-currency debt ended last Friday at 4.21%, little changed from a month earlier.

The relative stability points to a market that is not automatically following every move in developed-market government bonds.

“Emerging markets are well positioned,” says Eric Fine, head of active emerging markets debt at VanEck in New York.

Speaking to Bloomberg, he explains: “They are generally sound credits with independent central banks that have already navigated crises.

“Emerging markets broadly would be winners, as they represent alternative reserve assets,” he adds.

Sentiment at play

Even so, a stronger overall position does not mean emerging markets are immune to a fresh European debt shock. Investors will need to distinguish between countries with manageable financing needs and those whose fiscal vulnerabilities could become more pressing if borrowing costs rise further.

“Liquidity can deteriorate much faster than economic fundamentals,” says Lyndon Man, co-lead of Invesco Global Investment Grade Credit in London, warning that markets could suddenly focus almost entirely on fiscal weaknesses.

Brazil is one country attracting particular attention. Its nominal fiscal deficit has climbed to nearly 10% of gross domestic product, while public debt has exceeded 80%, leaving investors increasingly sensitive to the government’s ability to manage its finances.

The political outlook has, nevertheless, provided some support to Brazilian assets. They rallied last week after the more market-friendly Flávio Bolsonaro surged ahead of Luiz Inácio Lula da Silva in the first round of the presidential election.

For investors, the challenge is whether “improving sentiment following recent political developments is ultimately matched by credible fiscal implementation”, Man was quoted as saying by Bloomberg.

Central and Eastern European (CEE) economies could face a different set of pressures because of their close economic and monetary links with the eurozone.

“CEE member countries of the European Union would be the most vulnerable in emerging markets to any disruption within the eurozone itself, given that their economies and monetary policies are so intertwined,” Simon Quijano-Evans, a senior emerging-market strategist at Macro Hive in London, tells Bloomberg.

Poland is already facing fiscal pressure. Moody’s Ratings downgraded the country’s sovereign credit rating by one notch to A3 in September, highlighting the risks facing investors if European borrowing costs rise further.

The broader concern is that a renewed sell-off in developed-market bonds could push financing costs higher across emerging economies, particularly those that rely heavily on foreign capital to fund budget and current-account deficits.

Jeff Grills, head of US cross markets and emerging-market debt at Aegon Asset Management, tells Bloomberg a further increase of 50 to 100 bps in developed-market borrowing costs could make financing more difficult for emerging economies, especially those with large fiscal or current-account deficits.

That leaves investors weighing not only the possibility of market volatility but also the potential opportunities it could create.

Less sensitive

Some see a European debt crisis as a chance to acquire emerging-market assets at more attractive valuations, particularly if any initial sell-off proves disproportionate to the underlying economic risks.

The 2011 episode offers a precedent. Edwin Gutierrez, head of emerging-market sovereign debt at Aberdeen Investments in London, says the crisis “ended up being a massive buy opportunity”.

This time, emerging-market debt should be less sensitive to movements in European government bond yields, he says.

Aberdeen is positioning for a possible European crisis by favouring local-currency bonds in frontier markets such as Nigeria, Egypt and Kazakhstan.

These securities, Gutierrez says, are “not correlated to broader developed bond markets”.

As the market heads towards the coming weeks, the key question is whether renewed European debt concerns remain largely contained within the region or develop into a broader repricing of global risk.

For emerging-market investors, stronger fundamentals may provide a cushion, but widening fiscal deficits, external financing needs and the possibility of a sudden deterioration in liquidity will remain important considerations as they assess where resilience is strongest.