A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week
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June 9, 2014

Out of the depths: EM debt bounces back
Emerging market and US bond index yields

chart

Source: Barclays, as of 5/31/14. US$ EM Sovereign is represented by the Barclays EM USD Sovereign Index; US$ EM Corp is represented by the Barclays EM USD Corporate and Quasi-Sovereign Index; Local Currency Government is represented by the Barclays Emerging Markets Local Currency Government Index; and US Agg is represented by the Barclays Aggregate Bond Index Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line:

  • For fixed-income investors seeking attractive yields, emerging market (EM) debt has its allure. Whether US dollar-denominated sovereign, US dollar-denominated corporate, or local currency sovereign, EM debt yields are notably attractive compared those in the US.
  • But that worry flies in the face of many other economic indicators, including initial claims for unemployment insurance and inflation expectations, both of which are consistent with positive, if somewhat low-key growth.
  • Price performance has also been strong in recent months, rebounding from EM’s 2013 slide. The Barclays EM USD Aggregate Index has returned nearly 11% over the past nine months.
  • As a result, major EM index spreads narrowed to a level near its 2013 lows.
  • The world's major central banks have recently reiterated their commitment to continued monetary accommodation; those stances would be supportive for current price levels in the sector, given the importance of the richer developed countries as trading partners and sources of investment capital.
  • Yet investors are right to be concerned about the potential for economic, political and social unrest -- which has impacted Ukraine, Russia, Turkey, Brazil, Argentina, Venezuela, Thailand, China in recent months; reminders that EM investments can carry additional risks.
  • Of course, countries like Mexico, India, Philippines and South Korea, with strong GDP growth, serve as reminders that there are still sizable EM economies that are strengthening.
  • Understanding the opportunities as well as the risks in EM debt markets requires serious analysis. Whether it's individual credits and sectors, or the macro-environments of the individual markets, This isn’t something a passively managed strategy is designed to deliver, and argues for an active approach.

The Chart:

  • The chart shows the yield to worst for the Barclays EM US$ (USD) Sovereign, the Barclays EM US$ Corporate and Quasi-Sovereign, the Barclays Emerging Markets Local Currency Government and the Barclays US Aggregate Bond indices for the period 6/30/11-5/31/14.
  • The shaded area highlights a period of sharply rising rates last summer that came to be popularly known as the taper tantrum; a sell-off occurred in many parts of the global bond market following the US Federal Reserve's (Fed) first mention in early May 2013 of its plans to reduce, or taper, its asset purchases.
  • Note that the rally (and the resultant decline in yields) since late last summer has occurred to varying degrees among all three segments of EM debt shown in the graph: yields have fallen the most in the US$ EM corporate sector and the least in the local currency sector.

Context & Perspective:

  • As of 6/3/2014 the yield to worst of the Barclays EM US$ Sovereign Index was 4.89%; the yield to worst of the Barclays EM US$ Corporate and Quasi-Sovereign Index was 4.55%; and the yield to worst of the Barclays Emerging Markets Local Currency Government Index was 5.49% -- compared to 2.28% for the Barclays US Aggregate Bond Index. (Source: Barclays)
  • Between 5/9/2013 and 9/5/2013—following the Fed's announcement that it might begin reducing its Quantitative Easing program—the yield of the Barclays EM US$ Aggregate Index rose 173 basis points from 4.03% to 5.76%. During this same period, the index total return was -8.83% (-10.52% in price terms offset by 1.69% of reinvested coupon over that four month period).
  • During that period, the market seemed to interpret the Fed’s comments as a sign that that accelerating global economic activity was ahead – and the short-term interest rates might rise faster than was expected.
  • If that were to have happened, it could have had significant impact on liquidity-sensitive EM debt markets - which could be one reason the sector underperformed US debt during the May-September selloff.
  • As the belief in accelerating global growth has moderated, so has much of the concern about rapidly rising rates. In turn, that has likely facilitated a bond rally over the past nine months—during which EM debt has outperformed US debt.
    From the yield high of 5.76% on 9/5/2013, the Barclays EM USD Aggregate Index yield fell to 4.63% on May 29, 2014 (the yield was 4.68% on 6/3/2014), still 60 basis points above the 2013 low.
  • From the yield high of 5.76% on 9/5/2013, the Barclays EM USD Aggregate Index has returned 10.93% through June 3, 2014. Total returns for three sector indices shown in the chart during this time period were 12.87% for the Barclays EM USD Sovereign Index; 9.76% for the Barclays EM USD Corporate and Quasi-Sovereign Index; and 9.24% for the Barclays Emerging Markets Local Currency Government Index. By comparison, the return of the Barclays US Aggregate Bond Index during this period was 5.27%

Definitions:

Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

The spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security

A basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).

The Barclays EM USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. The index is broad-based in its coverage by sector and by country, and reflects the evolution of EM benchmarking from traditional sovereign bond indices to Aggregate-style benchmarks that are more representative of the EM investment choice set. Country eligibility and classification as an Emerging Market is rules-based and reviewed on an annual basis using World Bank income group and International Monetary Fund (IMF) country classifications. This index was previously called the Barclays US EM Index and history is available back to 1993.

The Barclays EM USD Sovereign Index is the sovereign component of the Barclays EM USD Aggregate Index, which is a hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Investors cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

The Barclays EM USD Corporate and Quasi-Sovereign Index is the corporate and quasi-sovereign component of the Barclays EM USD Aggregate Index, which is a hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.

The Barclays Emerging Markets Local Currency Government Index is designed to provide a broad measure of the performance of local currency emerging markets (EM) debt.

The Barclays Aggregate Bond Index is an unmanaged index of U.S. investment- grade fixed-income securities.

Yield to worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

The U.S. Federal Reserve, or "Fed," is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Tapering refers to the Fed’s announced approach to reduce the pace of its monthly asset purchases gradually instead of ending the purchases all at once.

The taper tantrum refers to the sell-off in many parts of the global bond market that occurred following the Fed’s first mention in early May 2013 of its plans to reduce asset purchases.


The opinions and views expressed herein, as well as references to individual companies or securities, are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or recommendations to buy, hold or sell, or investment advice.

Past performance is not a guarantee of future results.

All investments involve risk, including possible loss of principal.

Yields represent past performance and there is no guarantee they will continue to be paid.

Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

Outperformance does not imply positive results.

Active Management does not ensure gains or protect against market declines.

Unless otherwise noted the "$" (dollar sign) represents U.S. dollars.

This material is for information only and does not constitute an invitation to the public to invest in any funds, securities, strategies or other products. You should be aware that the investment opportunities described should normally be regarded as longer term investments and they may not be suitable for everyone. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Past performance is no guide to future returns and may not be repeated. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Please note that an investor cannot invest directly in an index. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data. Individual securities mentioned are intended as examples of portfolio holdings and are not intended as buy or sell recommendations. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

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