Investors should look East if they want strong yields

Kathleen Brooks
FIXED income is at a cross roads. While yields on G3 government bonds continue to fall to record lows, investors are left in a quandary: put up with low yields because these are the “safest” bonds in the world, or sell their stakes and move into the higher-yielding debt of emerging markets.

Since the onset of the European sovereign debt crisis, the reliability of developed-world debt has been called into question. This has created an opportunity for emerging markets’ bond funds and investor interest in this asset class has been growing since the start of this year. According to EPFR Global, weekly inflows to global emerging market bond funds were $811m as of 11 August. And there is definitely room for this sub-asset class to improve –? inflows to US Treasuries run into billions of dollars every week.

It’s getting easier for investors to get exposure to this emerging market debt as more fund managers jump on the bandwagon. In May, Aberdeen Asset Management launched its local currency emerging market debt fund and yesterday, fund management firm ACPI launched an Indian Fixed Income fund.

The Bric countries look particularly attractive for investors. Not only are public finances in Brazil, China and – to a lesser extent –?India, in relatively good shape, but currencies in these countries are appreciating, which adds to total returns. Steve O’Hanlon, fund manager for ACPI’s India fund, also notes that liquidity in these markets has been improving for a number of years, resulting in deeper markets. For example, the Indian authorities have increased the amount of government debt that can be bought by foreigners from $5bn to $20bn in the past nine months. But this is still only equivalent to 5 per cent of all debt issued by the Indian government and there is scope for this to increase in the coming years.

ACPI plans to invest in both corporate and sovereign debt in India and it is targeting an
annual risk adjusted return of 10-12 per cent: “India has a sticky inflation rate and the Reserve Bank of India is basically behind the curve. The bank has to balance growth with inflation, and if they don’t want to hike rates any further, then they will have to let the currency appreciate to keep inflation at bay,” explains O’Hanlon.

A strong growth outlook in the emerging world is also making corporate debt look attractive. Mike Turner, head of global asset allocation at Aberdeen Asset Management, says that corporate bond markets, especially in Asia, have huge potential: “Companies are not leveraged and the fundamentals look good too. Growth should be self-sustaining in the coming years as domestic demand picks up. Even if global growth becomes unstuck in the East, then governments have the firepower to help support demand.”

After spending the last decade restructuring after the Asian and Russian financial crises at
the end of the 1990s, bond markets in the emerging world now look fairly robust. In Russia, for example, the bond market has returned 19 per cent in the last 12 months. Although there are still risks, Evgeny Korovin from Troika Dialog Asset Management, says that bond funds have performed fairly well in recent months when markets have been particularly tricky because of the European sovereign debt crisis: “If you look back at the market performance in 2008, then you can see lots of losses. However, during the peak of the European sovereign debt crisis, bonds were remarkably resilient.” For example, the Russian corporate bond index was flat in May and rose by 2 per cent in June, while other bond markets were tumbling because of the crisis in Europe.

China, the world’s largest holder of US Treasuries, sold more than $21bn of its holdings earlier this week, possibly because yields on short-term US debt had fallen too far. If investors feel likewise, then the hunt for yield should shift to the debt markets of the fast-growing, financially strong emerging markets.