Higher yields could make 2023 a good year for emerging-market debt
As difficult as 2022 was—and as precarious as the path forward could be for the global economy—we've entered the new year with expectations for less-aggressive monetary policy and reduced interest-rate volatility, which should be supportive of risk assets. There remains considerable uncertainty across both developed and emerging markets, but the likelihood that we’ve seen peak inflation and are near the end of the global monetary tightening cycle is encouraging.
Although clearly benefiting from easy comparisons, 2023 so far seems to be a more supportive year for emerging markets (EM). China’s abrupt end of its zero-COVID policies and accelerated reopening are helping the macro case for EM, possibly opening the door for some GDP forecasts to surprise to the upside. An unusually mild winter in Europe has diminished concerns that high energy prices would significantly stunt growth. U.S. economic indicators are suggesting a potentially weaker dollar and lower yields as the year rolls on; a diminished yield advantage in the United States versus the rest of the world would offer another powerful tailwind for EM. With elevated yields and attractive relative valuations, we believe EM debt (EMD) is worth considering for global investors searching for income and competitive total returns.
Starting yield is a key component of total return
It’s worth bearing in mind some of the mechanics that dictate performance in the fixed-income markets. Under normal circumstances, when investors buy a bond, they earn that bond’s coupon payment for the life of the loan and receive return of their principal at maturity. That’s why the starting yield of a bond is frequently a reasonable predictor of expected return.
In the reality of a live market, risk premiums, as reflected by spread levels, can move materially, inflation expectations can change, issuers’ financial strength (credit risk) may improve or deteriorate, liquidity considerations and a host of other factors can affect the actual return experienced from purchase to the sale of a bond. Leaving these real-world considerations aside (or better yet, in the hands of an experienced investment management team), there are some conclusions that can be drawn when comparing starting yield with total returns within the EMD market.
More than half of rolling 1-year returns are positive
Rolling 12-month returns for the J.P. Morgan EMBI Global Diversified Index since December 2010
Source: J.P. Morgan, as of December 31, 2022. The J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified Index tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities, capping exposure to countries with larger amounts of outstanding debt. It is not possible to invest directly in an index. For a more detailed explanation of this chart, please refer to the endnotes.
It's no surprise that EMD was an extremely volatile asset class in the immediate wake of the global financial crisis. But if we look at monthly rolling one-year returns since December 2010, we see that the majority of return observations (roughly 75%) are positive, with slightly more than half of those one-year returns offering performance greater than 5%. It’s worth noting that all the double-digit negative returns were recorded over periods ended in 2022.
The overall positive skew of the return series highlights the power of yield (coupon income) for the asset class. The dramatic drawdowns during 2022 also highlight the impact of real-world factors: geopolitical crises (such as the Russian invasion of Ukraine), central bank intervention (U.S. Fed interest-rate normalization followed by more of the same from most central banks across the globe), industry challenges (such as within the China property sector), and a major shift to risk-off sentiment from investors (roughly US$90 billion in asset class outflows from EMD in 2022).
Higher yields in EMD have historically led to higher returns
Bearing in mind the dispersion of returns over the past 12 years, let’s examine more closely the role of starting yield in subsequent performance. To illustrate this point, we’ve filtered the same performance series—monthly rolling 1-year returns since December 2010—but included only those periods when the starting yield was at least 5.5%.
Higher yields increase the likelihood of a positive 1-year return
Rolling 12-month returns for the J.P. Morgan EMBI Global Diversified Index since December 2010 when starting YTW >5.5%
Source: J.P. Morgan, as of December 31, 2022. Yield to worst (YTW) is the lowest potential yield calculated by taking into account an issue’s optionality, such as prepayments or calls. The J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified Index tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities, capping exposure to countries with larger amounts of outstanding debt. It is not possible to invest directly in an index. For a more detailed explanation of this chart, please refer to the endnotes.
The positive shift in outcomes is quite noticeable. All but two of the observations are positive, and 85% of the one-year returns are better than 5%. It’s worth noting that the two negative return periods occurred as result of risk-off market drawdowns after the Russian invasion of Ukraine.
While no investment strategy can guarantee positive returns, the advantage of starting with higher yields for fixed income is undeniable; more coupon income can cushion a portfolio against shorter-term market fluctuations and also compound higher total returns over the longer term. While many headwinds still exist in EMD, we believe that valuations have already priced in much of that reality. With yields for the J.P. Morgan EMBI Global Diversified Index at 8.07% as of January 20, 2023, we believe history suggests this could be an attractive entry point for investors with enough risk tolerance to ride out the near-term volatility.
Endnotes: Analysis uses monthly time series for returns over rolling 12-month periods; for example, from January 2011 to December 2011, from February 2011 to January 2012, and so on. The bars in the charts reflect the number of observations within various ranges of returns; for example, per the tallest bar in the first chart, there have been 25 discreet 12-month periods in which EMD returned between 10.0% and 12.5%. In the second chart yield is represented by the yield to worst of the J.P. Morgan EMBI Global Diversified index. Yield to worst is the lowest potential yield, calculated by taking into account an issue’s optionality, such as prepayments or calls.
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