Market Opinion Fixed Income

Market Opinion:

Fixed Income EM Debt Still Looking Good

When we talk about the search for yield, where better to look than emerging market (EM) bonds. We have long promoted their impressive fundamentals. The growth outlook across the asset class is sustainable, helped by high commodity prices and increased levels of domestic demand. In addition, fiscal dynamics are ever improving. Indeed, due to sound monetary, exchange rate and fiscal policy decisions, ability to pay back debt obligations is improving, leading to greater credit worthiness. This has lead to numerous credit rating upgrades, with momentum for future upgrades still strong. Recently too, EM bond prices held steady amidst US Treasury market volatility, a further sign of the asset class’s maturity and superior fundamentals. As a result, the latest easing of the US 10-year yield has seen the more solid EM credits move to all-time highs. From a technical perspective, this is a great sign. Readers will know that we have long favoured the Russian US$ Global 30 instrument. Sure, there are some long-term concerns surrounding the Russian economy - such as property rights, fear of the foreign investor, and lack of diversification away from the natural resources sector – but the debt market dynamics are too good to ignore. The government is a net external creditor, while foreign exchange reserves continue to grow substantially due to revenues from high commodity prices. However, it is not just Russia that is performing well. Check out the Latin markets, and in particular Colombia, Peru, Mexico and Venezuela. However, given that the market is trading at all-time highs, and that there is a heavy election schedule across the asset class in 2006, correction talk abounds. So what will make the latest appreciation sustainable? Well, quite simply, it could be the weight of inflows coming into this asset class, as demand for solid, higher-yielding credits gathers pace. So long as the fundamental outlook stays positive, which we think it will, this global search for yield should drive prices of EM external debt, and perhaps more so local debt, higher. Moreover, as we have mentioned lately, although there are clearly upside risks to US inflation from the cost of energy, the outlook for long-term inflation is relatively benign. This will keep US Treasury yields low on an historical basis, despite short-term upside risks. Against this backdrop, emerging markets are an obvious destination for fund managers looking to increase return on investment.