Schroders Quickview: Has the Fed hike actually made emerging markets more appealing?

Now that the Federal Reserve (Fed) has raised rates, investors may start to view emerging market debt in a new light.

17 December 2015

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Fed factor

The Fed appeared to meet expectations with its long awaited rate hike last night, coupled with a forecast that was widely viewed as gradual and fairly predictable, if not outright dovish.

While all asset classes had waited for the Fed to move, emerging markets had arguably been one of the most affected, given that the average currency in the asset class has fallen roughly 40% since May 2013, the beginning of the infamous “taper tantrum”1 that marked the beginning of rate hike speculation.

It is difficult to argue that the Fed has been the sole factor in emerging market bond weakness.

China hard landing fears, plummeting commodity prices, Brazilian political disarray, Russian policy concerns, and general weakening growth across all regions created a near perfect-storm for emerging market bond investors.

Settling nerves

However, a more predictable and less fraught path going forward for the Fed should help steady investor nerves and risk appetite.

If developed market bond yields remain very low - as seems likely with a very slow hiking path set out with some confidence - emerging market dollar yields will remain one of the few places to look for meaningful income generation for years to come.

The Fed move comes at a time when emerging market dollar bonds seem particularly attractive.

Yields in the primary sovereign dollar index are at highs not seen since 2010, when Treasury yields were much higher than today.

Diverging monetary policy

Yield spreads over Treasuries for investment grade2 sovereign bonds are just under 300 basis points, and remain at elevated levels that were last seen consistently during the European crisis of 2011. High yield3 sovereign debt currently has a yield to maturity of 8.5%.

The divergence between developed market monetary policies has driven the dollar nearly 20% higher on a trade-weighted basis since July 2014.

Emerging market currencies have fallen in lock step.

With the European Central Bank now charting a path towards a steady dose of quantitative easing as growth in Europe stabilizes, Fed predictability should help curb that dollar appreciation.

Emerging market currencies should then likely steady at attractive levels, boosting sentiment towards the asset class.

Even a modest virtuous cycle led by those factors could make emerging markets one of the strongest global fixed income performers next year, given today’s generous yield levels.

1. The term ‘Taper Tantrum’ refers to the surge in US Treasury yields (global government bond yields as well), in the summer of 2013 when then-Fed Chairman Ben Bernanke referenced the potential wind down of Fed asset purchases (tapering off QE).

2. Investment grade bonds are the highest quality bonds as assessed by a credit ratings agency. To be deemed investment grade, a bond must have a credit rating of at least BBB (Standard & Poor’s) or Baa3 (Moody’s).

3. A high yield bond is a speculative bond with a credit rating below investment grade. Generally, the higher the risk of default by the bond issuer, the greater the interest or coupon is.

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