Emerging Market Debt: The Coupon Challenge

Mid Week Bond Update

Emerging Market Debt: The Coupon Challenge

EM Income is a plus for investors; for EM economies, the issue is more nuanced.

Current income is a key objective for many investors – and one of the attributes of Emerging Market (EM) debt as an asset class.  So it’s little surprise that many investors have turned to Emerging Market bonds for income, attracted by relatively high yields; the average yield-to-worst for hard-currency EM bonds is 5.63%, and for local-currency EM government bonds, 5.08%.[1]

As Brandywine Global observes, coupon income[2] flow to U.S. investors in EM bonds has been a substantial contributor to a rapid increase in foreign-source net income flowing to the U.S. – especially since the boom in U.S. ownership of non-U.S. bonds that began in earnest in 2010.


Chart: U.S. holdings of non-U.S. bonds contributed to U.S. net  inflows

Chart Courtesy of Brandywine Global. Source: Haver Analytics, as of 9/30/2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
 

Unfortunately, this increased outflow of capital poses a challenge for EM economies in general.. For issuing countries, the result can be added economic pressure on countries already grappling with other challenges. Brandywine Global cites South Africa as a case in point; Turkey, Argentina and Brazil might also be seen in this context.

 

On the rise:  Swiss franc

While the 0.63 percent rise in the Swiss franc vs the euro over the past five days doesn’t seem significant in itself – it brings the currency up to €1.124 from its December 10 value of €1.130 – it’s likely a reflection of significant  events elsewhere in Europe.  Consider that the British pound is down 2.25% over the same period.

It’s understandable  that the chaotic and as-yet unresolved political environment surrounding Brexit could keep the pound volatile and promote demand for the relative stability of the Swiss currency. Similarly, the slight downward move against the euro could reflect to the severity of the protests in France, which make adherence to the European Union’s budgetary discipline seem increasingly difficult.
 

On the slide: U.S. Treasury yields

Talk of the inversion of the U.S. yield curve may have overshadowed another key development – the downward move of the 30-year Treasury, from about 3.1735% to 3.1265% over the past week – well below the 3.385% level a month ago – a fall of some 26 basis points.

While both levels are still well above the 2.74% yield reached at the beginning of 2018, the recent downward moves may reflect a decreased belief on the part of the bond market that the current pace of economic growth can continue.  And perhaps more significantly, the move may indicate that the Fed’s 2% target for inflation is becoming increasingly difficult to achieve in the coming year.  If the FOMC takes these moves into consideration during its meeting next week, its quarterly economic forecast could contain some notable changes, both from its previous forecast and from the market’s own recent past.

 


[1] Source: Bloomberg, December 12, 2018. EM hard-currency bonds are represented by Bloomberg Barclays EM Hard Currency Index Yield to Worst; local currency EM bonds are represented by Bloomberg Barclays EM Local Currency Government Bond Yield to Worst.

[2] "Coupon" refers to a bondholder's receipt of income payments as a result of owning the bond.  The term stems from the coupons which were physically attached to bonds, and which bondholders redeemed by removing, or "clipping," and sending it to the issuer to receive payment.

Definitions:

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

 

[1] Source: Bloomberg, December 12, 2018. EM hard-currency bonds are represented by Bloomberg Barclays EM Hard Currency Index Yield to Worst; local currency EM bonds are represented by Bloomberg Barclays EM Local Currency Government Bond Yield to Worst

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[1] Source: Bloomberg, December 12, 2018. EM hard-currency bonds are represented by Bloomberg Barclays EM Hard Currency Index Yield to Worst; local currency EM bonds are represented by Bloomberg Barclays EM Local Currency Government Bond Yield to Worst.

 
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