Emerging bond funds primed for inflow rush

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For an idea of how much further the bull run in emerging market bonds can go, take a look at where the world’s biggest money managers are invested.

Global bond funds overseeing $13.7 trillion have been slowly returning to the asset class after they cut holdings to the lowest level since the financial crisis during the 2015 oil crash, according to data from the Institute of International Finance. But their allocations, at about 11%, are still some way off the almost 14% peak reached in 2013.

A return to that level would unleash $350 billion of new inflows. Morgan Stanley and JPMorgan Asset Management say conditions are right for the floodgates to open.

“People have been picking up allocations over the past year or so, but there’s more to go,” said London-based Iain Stealey, who manages JPMorgan’s $4.1 billion Global Bond Opportunities Fund, which has doubled allocations to emerging markets in the past year to 20%. “The fundamental picture has shifted a lot and we’re much happier owning emerging-market risk than we were 18 months ago.”

The bonds of developing nations have become the darlings of investors in 2017 after the U.S. Federal Reserve signaled it will raise interest rates only gradually, boosting the appeal of higher-yielding assets. The economic backdrop has also improved, with oil-exporting nations from Russia to Brazil returning to growth for the first time since the energy slump in 2014-15.

Top emerging market bond funds over 3 years
Fixed income has posted steady returns in these markets, while once high-flying equities have come crashing down.

Still, while many have exited recession, fixed their balance sheets and survived the slump in commodities prices, emerging-market borrowers will see refinancing costs rise with higher U.S. rates. Meanwhile their own currencies could strengthen so much that they undermine export competitiveness, prompting counter-action from policy makers.

But for now those risks aren’t holding back a wave of $38.6 billion of new investments to emerging market funds in 20 straight weeks of inflows, according to Bank of America Merrill Lynch research citing EPFR Global data. The surge in demand has pushed average yields on emerging-market sovereign dollar bonds down to 4.48%, close to the lowest level in seven months. That’s still 362 basis points more than an investor can earn on equivalent government bonds in developed countries, according to Bloomberg index data.

The largest ETFs that track the two asset classes posted about $3.1 billion of withdrawals last week.
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Developing countries got a bad reputation among global investors during the oil rout because it was unclear how the big energy producers would respond to the shock, according to Gordian Kemen, a strategist at Morgan Stanley in New York.

Confidence has been restored now that most of the major exporting countries have adjusted to lower prices, Kemen said. Morgan Stanley recommends buying corporate credits in commodity producing-nations Argentina, Indonesia and Russia among its top cross-asset trade ideas for the second half of the year.

“There’s fundamental evidence that the imbalances have been repaired,” Kemen said. “We don’t see a lot of downside from here.”

Bloomberg News
Bond funds Interest rates Emerging markets Global investing Federal Reserve JP Morgan Asset Management Bank of America Merrill Lynch Morgan Stanley