By Lyxor Asset Management’s ETF research department.

The emerging solution to investors’ search for yield.

Nothing seems to be making developed market bond yields rise at the moment, leaving investors with a serious headache – where can they find the income they need? One answer might be in emerging market bonds. Even though they’ve rallied with most other risky assets this year, there is reason to believe they could rise further from here.

An expanding market

Bond markets have become an increasingly important source of financing for both the public and private sectors since the mid-1990s, especially in emerging markets. Several developing countries have opened their local markets to foreign investors over this time to widen and diversify their investor base. Foreign participation has also helped spur the development of robust market infrastructure and more transparent market practice. Emerging debt now accounts for nearly 30% of the total global fixed income market.

Source: Lyxor Asset Management.

In high demand

Recent demand for emerging debt has been driven by investors searching for returns above inflation at a time when US Treasury yields are low and those of German Bunds have fallen below zero once again. Barring the recent market downturn, there have been strong inflows into the asset class since the beginning of the year and these have been accompanied by an impressive rally in emerging market rates, especially in China, Russia, Mexico, and Brazil.

Source: Lyxor Asset Management.

A supportive backdrop

Can emerging bonds rally even further this year? Subdued US rates expectations and easier external funding conditions continue to offer breathing space for those emerging markets with heavy FX and/or external debt burdens.  Many emerging countries have started to improve their trade balances through cheaper exports and by fighting inflation via rate hikes. Most hold relatively high foreign currency reserves, which could help them service their debt if necessary. What’s more, the market volatility in late 2018 led many emerging issuers to put off offering new debt. The level of supply was 15% lower in the first quarter of 2019 compared to Q1 last year and future supply is likely to remain contained.

Issuance for the first quarter of each year

Source: Lyxor Asset Management.

There are other supportive factors to consider. Lower inflationary pressures mean there is ample scope for central banks to cut rates in Asia and elsewhere. The outlook for the US dollar is quite stable at present, providing support to the outlook for hard-currency bonds. Emerging bond investors will also be carefully assessing whether the rebound in Chinese growth continues into the second half of the year and into 2020, as this is likely to have big implications for the asset class.

Passive and active emerging debt investments with Lyxor

At Lyxor, we offer both passive and active emerging debt strategies. If you’re looking to closely track the performance of an emerging market bond index, our ETF replicates an index of large, liquid USD-denominated government bonds issued by 20 emerging countries.

The index is well diversified, with the Middle East & Africa accounting for over a third of its holdings, Latin America over a quarter, and about a third split between Asia Pacific and Europe. And because the underlying bonds are issued in hard currency (USD), there is no exposure to emerging FX risk. If credit risk is a concern, it’s worth noting that the index is evenly split between investment-grade and high-yield bonds.

Source: Lyxor Asset Management.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)