The relentless global search for yield. The penchant of foreign investors - in an age of financial repression and abundant liquidity - to focus on positive market technicals, rather than poor economic fundamentals. And no sign that generating positive real returns on creditworthy sovereign bonds in the West will be mathematically feasible this year.
That's the backdrop to a strong rally in emerging market local currency bonds in recent months, which has unnerved some battle-hardened EM veterans.
Average yields on EM local currency bonds were 5% during the past 12 months, based on returns from the Market Vectors Emerging Markets Local Currency Bond ETF, compared with 1.8% on the Fed’s 10-year treasury note. With monetary easing in developed economies keeping interest rates near historical lows, there has been a rush to pick up the extra returns available from cash-rich exporting nations.
Investors are betting that softer growth in emerging economics this year will keep inflation and interest rates under control, a boost for bond positioning in the current environment.
“My sense is that in the local currency bond market there’s less of a reason to be concerned, certainly for the next year or so, because the low level of yields is justified by what is still a challenging growth outlook for a number of emerging economies and the fact that inflation is coming down,” says Neil Shearing, chief EM economist at Capital Economics.
“A bubble is when the yield, or the price, is not justified by fundamentals. In this case, local currency yields are just the sum of the expected path of short-term interest rates as a term premium.”
Given the fact growth is weak in a number of places and inflation is slowing, shorter-dated bonds at least should continue to perform, says Shearing.
“There have been concerns about the low level of yields in the Polish bond market and Brazil but inflation there has peaked, while in Poland and eastern Europe inflation is going to continue to edge down over the course of this year. That provides an anchor for yields, particularly at the short end of the curve.”
He adds that the picture across EM bonds and equities is one where the outperformance relative to developed markets has ceased during the past three-to-four months, reflecting a scaling back of expectations for QE in developed markets and growth problems in emerging economies.
However, the growth picture of EMs is mixed with a rebound in Asian exports possibly signalling a new round of economic expansion, particularly if the US recovery accelerates towards the end of this year.
Mexico and the Andean economies are also proving resilient, but many of the larger EMs – Korea, South Africa, Argentina, Poland and most of emerging Europe – have growth problems.
Another support for the market is lack of issuance. There were 329 EM local currency government and agency debt deals last year, raising more than $112 billion, compared with 278 hard currency deals, according to Dealogic in London.
However, this year has seen a dramatic tail-off, with local currency deals numbering 34 year-to-date, from 113 in the same period in 2012.
One reason for the decline in issuance could be that emerging economies are reducing borrowing as access to alternative funding sources, such as direct investment, becomes available.
IMF figures show the average debt-to-GDP ratio for countries in the developed world is at 114% and rising, while in emerging economies it is just 34% and falling.
This fiscal health supports a continued decline in EM yields relative to developed economies, according to IMF methodology, which says that over the long run yields rise as debt-to-GDP ratio increases.
Significantly, the behaviour of EM bonds since the global financial crisis has moved closer to the characteristics of safe assets, according to the Bank for International Settlements.
Tristan Hanson, head of asset allocation at Ashburton, warns that with yields very low, the exchange rate is key and that cash might be a match for bonds in some markets.
“This is an area where you do risk bubbles, but it depends how close you think you are to that bubble ending,” he says. “The further yields go down the less room there is for appreciation and the more important the currency is going to be as a determinant of your returns.
“Just because yields are low it doesn’t mean bonds are over-valued if you think interest rates are going to stay very low,” says Hanson.
“The risk would be in countries where inflation is potentially going to be a problem – countries where, if we look five years down the road if they maintain current monetary policies, are those policies going to prove to have been too loose for what that country needs in terms of taming inflation.”
Malaysia and Mexico are markets Hanson favours. With Mexico he says that inflation trends are encouraging and that he expects rates to stay fairly low and that a recent rate cut further lowers the risk of any imminent monetary tightening.
However, Hanson stresses that versus Mexican cash, he is not convinced there is a lot of upside left in Mexican bonds.
“Increasingly, you need to be selective as yields go low because if you’ve got a 3% yield that used to be a 10% yield the chance of making much more of a capital gain on that bond is pretty low, and so if there are large swings in the currency that will give some big moves,” he says.
“The Mexican peso is up 13% in the last 12 months while the rand is down 11%, so currency is becoming a big factor in terms of which countries do well within emerging markets.”
Profiting from local currency bonds in the future is likely to be as much a matter of judicious currency picking as second-guessing central banks, which suggests euro-sensitive local bonds in emerging Europe are particularly at risk if the US economy continues to outperform Europe.