An improved investment backdrop
The Fed has moved away from aggressive rate hikes as inflation has moderated and policy is in restrictive territory, with leading US growth indicators pointing to softening economic activity. The US central bank is getting closer to the end of its rate-hiking cycle, which we believe is likely by the end of the first quarter. Meanwhile, the risk of the Fed having to raise rates much higher than expected has diminished. At the same time, China’s rapid dismantling of COVID restrictions is paving the way for a faster-than-anticipated economic reopening, while policymakers are emphasizing the need for monetary and fiscal support to aid the domestic recovery, including measures to support the country’s troubled real estate sector.
Attractive yields and supportive technicals
EM bonds are starting the year with yields not seen since 2009: 8% for sovereign bonds (JPMorgan EMBIG Div.) and 6.8% for corporate bonds (JPMorgan CEMBI Div.). For investors, history shows higher yields typically result in higher returns over a 12-month horizon. While spreads on EM sovereign and corporate bonds have tightened in recent months, we expect further moderate tightening over our forecast horizon supported by signs of further progress on these drivers. EM bond funds have seen sizable inflows since the start of the year, which helps the market to digest new issuance.
Where are the opportunities...
We see value in sovereign bonds where current valuations are attractive relative to historical levels, driven by the high yield (HY) segment. The proportion of the index trading at spreads above 600bps remains elevated.
Within this category, we find value in some of the larger sovereign issuers that are willing and able to work with the IMF or other international lenders, or where we see upside to potential restructuring scenarios.
We also see opportunities in short-duration EM bonds from issuers we deem to have sound fundamentals, and in bonds of energy exporters across the Gulf region and in other emerging markets. We also highlight other opportunities in our report In search of a Fed pivot, published 18 January, as well as in our weekly bond recommendation list.
...and the risks?
To be sure, risks remain elevated and bond spreads provide fairly limited buffers. In particular, we have yet to see the full economic impact of the tightening efforts by the Fed on the global economy, and a key risk for our constructive view on emerging market bonds is a sharp US recession. Also, markets revised expectations for China’s growth rebound sharply higher in recent weeks, which provides room for disappointment.
Main contributors: Michael Bolliger and Tatiana Boroditskaya
Read the latest monthly guide Investing in emerging markets 25 January 2023.
This content is a product of the UBS Chief Investment Office.
