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EM Debt Lures Income Hunters -- Barrons.com

1 Apr 2017 4:31 am
By Dimitra DeFotis 

Emerging Markets

The opening quarter of 2017 was a pleasant surprise to emerging-market bond investors. Following a late 2016 nosedive after Donald Trump's election, dollar-denominated emerging-market debt provided a total return of about 4% in the first three months and net inflows of roughly $20 billion into developing-country bond funds.

So what happened? Initial fears about the extent of U.S. protectionism seem to be overdone and have subsided. The Federal Reserve's rate hikes have remained pretty close to script. In addition, currencies have proved resilient with many big emerging market economies like Brazil and Russia remaining in growth mode. Bottom line: The higher yields available from emerging market debt proved attractive sources of income as the quarterly inflow figures, provided by the fund trackers at EPFR Global, suggest. The iShares JPMorgan U.S. Dollar Emerging Markets Bond exchange-traded fund (ticker: EMB) yields 4.6%, while the 10-year U.S. Treasury yields just 2.4%.

Representing dollar-denominated sovereign debt, the JPMorgan Emerging Market Bond global diversified index's solid 4% return actually didn't match the returns generated by the local currency debt of many government borrowers. During the quarter, local-market debt from countries like Brazil, Russia, and Mexico contributed to gains of about 7% as rising currencies helped returns.

LOOKING AHEAD, both local currency and dollar-denominated sovereign bonds have appeal, says Pierre-Yves Bareau, a portfolio manager at JPMorgan Asset Management who leads a team overseeing $43 billion in emerging market debt. Bareau favors countries whose economic cycles are on the mend, and suggests caution toward lower-yielding bonds correlated to the rising U.S. rate cycle. Those would include bonds from Poland, the Czech Republic, Malaysia, and Thailand.

Currencies are key, as we noted in our January outlook (" Playing Emerging Markets Bond Funds in 2017," Jan. 21). For example, the Mexican peso jumped 11% against the dollar in the first quarter, generating additional returns for the debt, and the Russian ruble gained 10%, providing a substantial boost to the bonds. Relative to many currencies, the U.S. dollar didn't match bullish expectations. In Turkey, the lira sank another 3%.

Russian bonds remain attractive, says Bareau, because money is coming out of dollar-based investments and going into domestic plays, reflecting an improving Russian economy, an improving commodities outlook, and favorable central bank policies. The 10-year Russian government bond yields about 8% with its inflation-adjusted real yield nearer 4%. Compare that to the U.S. 10-year U.S. Treasury, which barely yields anything after inflation.

But not every emerging market country is on firm footing. Despite the recent currency gains, Mexico faces challenges, with a revamp of the North American Free Trade Agreement and domestic elections on the horizon. Moody's Investors Service lowered Turkey's credit outlook to negative in mid-March, given its weak currency, weak growth outlook, and external financing needs. And political risk remains high on the eve of an April 16 referendum that could give President Recep Tayyip Erdogan and his party more control.

Emerging market bonds are appealing, but expect some second-quarter volatility, Bareau says. And shop for yield in economies with bright prospects.

Email: dimitra.defotis@barrons.com

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(END) Dow Jones Newswires

April 01, 2017 00:31 ET (04:31 GMT)

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