Have you raised your allocation to emerging market bonds? If not, what would be the catalyst for you to do so?
Hit by hawkish Fed rate hikes in 2022, emerging market (EM) hard currency corporate bonds delivered their worst total returns since 2008, down by 13.8% last year. We expect an improved investment outlook for EM bonds in 2023 as the US rate-hiking cycle is approaching its end by the middle of this year and EM credit fundamentals remain strong. The overall EM bond market, especially Asia credit, should benefit from China’s growth recovery, the peak in the US dollar and US Treasury yields, the imminent end of the Fed's policy tightening, conservative investor positioning, and appealing valuations.
Since the beginning of this year we have maintained an overweight allocation to EM corporate debt to capture their attractive spreads. But we remain selective, with a strong focus on higher-rated quality issuers within those markets. Excluding Chinese property developers and Russia-Ukraine issuers, EM high yield corporate default rates remain comparable with US high yield at 1.8%.
We are overweight on Asia investment grade bonds and higher-rated issuers from the Middle East, Brazil and Mexico. We selectively invest in strong credits issued by EM commodity producers and financial and technology companies. In China, we prefer Chinese state-owned developers, technology bonds and quality financial credit.
We stay neutral on the EM local currency debt market as elevated global risks and rate volatility add pressure on EM nations’ fiscal and current accounts. We will wait for improvement in the global cyclical outlook, recovery in investor risk sentiment, and further weakening in the US dollar as catalysts to raise our tactical allocation to EM local currency debt to an overweight from neutral.
Have you raised your allocation to emerging market bonds? If not, what would be the catalyst for you to do so?
EM credits have historically been more sensitive to global risk-offs and with higher correlation to equities, calling for added defensiveness from an overall portfolio allocation standpoint. Credit spreads have staged a strong rally since October and we recently trimmed our EM exposure, cautious on valuations. But we expect most of the EMs to continue growing through 2023 despite the expected slowdown across the US and major European economies, and we will increase allocations once we find better entry levels. Geopolitical risks are still something to monitor, but macros remain supportive for many of the stronger EMs, particularly the ones in Asia.
Asian quasi-sovereigns remain among our preferred pockets, continuing to offer attractive pickup over comparable developed market peers across shorter tenors. Dominated by higher-rated single-A/AA credits, Middle-Eastern credits also remain key diversifiers for us, adding better resilience to portfolios on the downside. Africa remains a landmine (or a goldmine full of tactical opportunities), but calls for extra tact and caution. Political developments dominate the LatAm space and we have seen some noise settling there, and while hard currency credits are currently looking tight, the sharp policy rate hikes are now making US dollar-funded carry trades look attractive for local currency exposures.
