Is there any value left in EM local debt after the race to the bottom?

Nominal yields on local currency-denominated bonds in emerging markets (EM) are at all-time lows following a sharp cycle of interest rate cuts across countries both pre and post pandemic. Despite this, we believe there is still some value relative to developed markets (DM), and that low rates will not be an impediment to inflows to local EM bonds for the foreseeable future.

• A lower differential between EM and DM rates over the past few years has been a long-term trend, which has been sped up by Covid-19.
• The driver of this EM trend is vastly underappreciated: declining inflation, both in terms of volatility and overall level.
• Relative to DM, there is still value in EM, though undoubtedly a “margin of safety” provided by real rates has been eroded.
• We expect a stable floor on yields to form over the next 12 months, as central banks are sidelined and inflation stays low (with the possible exception of Central European EM). Coupled with under-valued currencies, the rationale for investing in local EM will be compelling in our view.

Why local rates have been on a long-term downward trend

The trend lower in local rates in EM is not a Covid-19 story. During positive cycles for EM assets, rates have trended down over the last five years. Meanwhile, during negative periods for the market, the high points for rates have been lower. Finally, during 2019, the trend took a decisive step lower, as illustrated in the chart below. 

It’s important to note that in 2018, the Federal Reserve (Fed) enacted four more incremental rate hikes. This means that  the EM trend has not been completely driven by the macroeconomic monetary policy environment; though surely its last leg down accelerated as the Fed lowered rates, beginning in August 2019.

But this acceleration could not have been possible without some key EM-specific factors: an increase in overall central bank credibility, tighter monetary links to regional developed economies with lower rates in Asia and Europe, and lastly, lower inflation virtually across the asset class.

Of course, central bank credibility comes only with policy consistency and low and stable inflation. And that has been an “under the radar” dynamic within EM that has been most responsible for the declining rates trend in our view.

EM inflation and its volatility has been falling for 20 years

Actual inflation in EM has been declining for two decades. Only a bump after the global financial crisis disturbed this trend. The current sharp drop in inflation may have been exacerbated by a growth slowdown, coupled with the pandemic. But even prior to this, inflation in EM was stable over a large number of years in a 3-4% range. 

Because inflation is measured somewhat differently in EM, this result is perhaps even more impressive.  Food is generally a much larger component of inflation baskets, usually making up about a third of the consumer price index measurement. Obviously, the declining price of high-tech goods has a less immediate impact, as EM consumers purchase less of these goods and more subsistence items, given lower per-capita incomes.

These factors have not stopped the volatility of prices from declining as well as the level. The chart below shows the decline in inflation volatility for countries that make up the bulk of the most commonly used local currency index.

What is notable is that the individual country outliers have structurally diminished over the past two decades, and once diminished, have tended to stick to the low volatility path. Similarly, those countries with more stable inflation at the start of the data set in 2000, like Poland, Thailand and Mexico, have not experienced any significant rises in inflation volatility. At least not long-lasting enough to suggest to the market that central bank credibility should be questioned.

Why this matters for EM rates

With lower inflation volatility comes more stable rates, since investors do not require a premium for increased uncertainty surrounding long run returns. Those more stable rates in turn tend to reduce currency movements in individual currencies as unanticipated policy events must be priced in. Lastly, foreign investors who participate in local markets become more “sticky”, in that they are less likely to move their money in and out of the asset class as often.

This last point can be illustrated by the reaction of foreign investors during and after the Covid market plunge of the first quarter. As macroeconomic fears mounted, investors left those local EM markets that tend to experience the highest participation of foreign ownership. But they returned to these markets afterwards, or as outflows levelled-off, suggesting there was little fear of longer-term damage to the credibility of the asset class described above. The chart below indexes the level of foreign ownership of local bonds, starting at 100 for January 2020 ownership, and it shows the path of participation during and after the episode:

Only Turkey — a country with light foreign ownership and the last significant country with high inflation volatility—has experienced a lasting and significant drawdown that has yet to stabilise.

The intersection of inflation and nominal rates is the real interest rate. This too, should be declining as a measure of central bank credibility won over the last decade of lower and more stable inflation. And that has been the case for EM as seen in the chart below:

We should note that the long-term rewards of lower real interest rates will be lower funding costs in local markets. This is a great opportunity to gradually evolve funding profiles more towards local markets at lower costs. This reduces the risk of a currency mismatch when funding debt in US dollars. Additionally, corporate local borrowing should deepen as well, which would enhance creditworthiness for significant swathes of the economy over longer time periods. 

But where does that leave local debt investors gauging future returns?

Like the rest of the world, expectations on returns have to move lower, but a meaningful yield cushion still exists relative to the developed world given the zero rates we see there.

We compare the yields available in the index minus the 10-year Treasury yield as an approximate comparison. The results do not materially change anywhere on the curve given the sharp overnight rate fall. The chart below shows we have spent considerable amounts of time in the last few years below current levels.

With EM inflation low and stable, and the Fed set to keep rates at current levels for multiple years, we could be in a narrow range of rate differentials for an extended period.

We include below a detailed analysis by country of historical yield spread to 10-year Treasuries. What is notable is how few countries show up as truly over-valued on this basis, with the bulk of them either fair value or undervalued.

With developed rates stuck at zero for years, plus low and stable EM inflation, local rates still offer some value in a world of more modest return expectations.