Emerging market (EM) bond allocations have risen to a three-year high, even as downgrades have pushed average EM sovereign credit ratings to their lowest level since 2010. EM bonds accounted for 11.5% of total bond fund industry assets at the end of November, up from a low of 9.7% in February 2016, according to the Institute of International Finance. The average rating for around 30 EM countries compiled by the three major ratings agencies has dropped below 11 this year; this level represents the lowest investment grade.
It’s unusual for flows and ratings to move in opposite directions, but we see reasons why investor interest in EM bonds makes sense:
- EM local currency bonds offer an attractive yield advantage of 3.6 percentage points (ppt) against US high grade bonds, slightly above the average premium of 3.5 ppt since 2003.
- Our global growth forecast is 3.8% this year and 3.9% for the next. Solid synchronized global growth will help support risk appetite for EM assets. Improved terms of trade due to reflation of commodity prices also support the EM bond equation, especially in LATAM and EMEA. We expect stable commodity prices in 2018.
- We also expect stable to strong EM FX, which will help moderate inflation across EM, favoring stable to lower interest rates.
We anticipate limited upward pressure on EM local currency bond yields, given the easing bias we expect in EM monetary policy. This contrasts with our forecast for gradually rising yields in advanced economies like the US. We remain overweight in a diversified basket of EM local currency bonds against high grade bonds.
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