By Jan Dehn and Gustavo Medeiros
Developed markets bonds offer negative yields, suffer from poor long-term macroeconomic policies and have exposure to debt levels that pose major risks for bond holders in the future, in our view. By contrast, emerging markets (EM) fixed income is not only relatively cheap, but also backed by much stronger economic dynamics and far less debt.
Two year and five year government yields in developed economies are now negative on average. To argue that these markets are not in a bubble is becoming less and less credible. Investors in developed market bonds are literally paying for the privilege of lending money to over-indebted, money-printing, reform-shunning developed market governments.
These governments are the most heavily indebted in the world with debt ratios of 138.5% of GDP, according to 2014 IMF data. Some USD 105 trillion of the world’s USD 120 trillion of bonds – 87.5% of the total – have been issued by developed economies despite that fact that developed economies only make up 44% of global GDP.
To make matters worse, these economies are also pursuing policies that are likely to lead to losses for fixed income investors. In the seven years since the Subprime Crisis, developed economies have undertaken virtually no reforms at all. Nor have they achieved any meaningful aggregate deleveraging – in fact issuers and investors alike appear to completely ignore the debt problem, perhaps because debt is easy to ignore when interest rates are zero.Instead, they have printed a staggering amount of money.
In a nutshell, these countries are all desperately trying to convert their debt problem into an inflation problem. They will eventually succeed, so the outlook for returns in these markets is ultimately dismal, because it hinges on continuing to inflate a bubble. The fact that a huge chunk of the world’s savings are parked in these fixed income markets means that the outlook for future generations is bleak.
The contrast with EM countries is startling: Not only are EM yields high and positive in nominal terms they are also positive in real terms by between 248bps (2yr) and 230bps (5yr) higher than in developed economies. 5yr Dollar bonds in the same EM countries today pay a yield in Dollars of 3.13%, which is a staggering 232bps over the nominal index yield in developed economies (0.81%).
Hence, from a relative value perspective the case for investing in EM fixed income as an alternative to developed market bonds is now very strong. But the case is also strong from a fundamental perspective. Firstly, EM has just been through three major shocks – a 25% fall in commodity prices, a 25% fall in their currencies and the loss of half of US and European mutual fund flows. Yet EM has come through these shocks largely unscathed (no defaults, no balance of payments crises, etc. across the 62-country EM universe – aside from the usual small number of idiosyncratic problem countries).
Secondly, EM countries are generally pursuing much better policies. They tend to reform regularly, and they are generally also quick and decisive in making fundamental macroeconomic adjustments when they get off course, not least because they never get the benefit of the doubt in the markets. This helps to keep them healthy. Finally, they do not print money and they have only issued USD 15 trillion of fixed income – 12.5% of the total – despite now making up 56% of global GDP. The average government debt to GDP ratio is only 44%.
We do not expect the world to become rational enough to price EM fairly despite the fact that EM’s better debt dynamics and better policies justify that debt in EM countries should trade tighter than debt in most developed economies. But at least investors should think of EM bonds as insurance. When developed economies ultimately succeed in generating inflation the best way to preserve purchasing power of assets will be to keep the assets issued by countries with less debt, faster growth, more reserves and less money printing.
Jan Dehn is head of research and Gustavo Medeiros is a portfolio manager at Ashmore
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