Casual observers of the bond market know that emerging market issuers and corporate paper tend to sport higher yields than Treasurys mostly because of differing perceptions of creditworthiness.
But that gap might not matter that much for even the riskiest of issuers, with heated demand for yield dragging borrowing costs for emerging market corporate debt down to pre-2008 levels. The Bank of America Merrill Lynch Emerging Market Corporate Bond spread, which measures the premium paid for owning bonds sold by corporations in developing markets against safer Treasurys, has compressed to 3.3 percentage points, the tightest since July 2007 (see chart below).
This narrowing gap demonstrates the continued rising tide of money flowing around the globe. This wave of cash has also swept into high-yield bonds, securitized debt and even dicey financial products many of which served as ground zero for the 2007-2009 financial crisis.
The steady inflows this year have pulled down yields for emerging market corporate bonds, pushing prices up to expensive levels. But in the risk-hungry environment, the positive yields on offer in emerging market corporate debt compared with the diminished rewards of owning European paper have made them a natural target for those chasing returns.
“As the period immediately prior to the financial crisis demonstrates, it is possible for credit spreads to fall below current levels without investors immediately becoming concerned that they are excessively low,” said Oliver Jones, a markets economist for Capital Economics.
Foreign investors plowed around $170 billion into the assets in 2017, up from $99 billion in 2016, according to data from the Institute of International Finance, a global financial industry trade group
The iShares J.P. Morgan USD Emerging Markets Bond ETF
one of the largest exchange-traded funds to track the sector, has seen inflows of $880 million so far in the new year, according to FactSet, second only to the SPDR Bloomberg Barclays High Yield Bond ETF
among inflows into fixed-income products. Another fund, the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF
has seen inflows of $165.4 million, also putting it in the top 10 of bond ETF inflows in the early days of 2018.
Issuers have taken advantage of the solid demand. Total sales of emerging market corporate bonds neared $500 billion in 2017, according to Thomson Reuters.
But the enthusiasm for the asset class isn’t just a reflection of investing fervor, but springs from genuine sources.
Fitch Ratings said emerging market corporations flogging bonds were seeing a rapid improvement in their finances. The net percentage of issuers with a positive outlook versus a negative one has risen to its highest levels since 2013 (see chart below). Credit ratings firms tag an issuer with a positive outlook as a prelude to a potential upgrade.
Emerging markets have profited from two major trends sweeping across the world. Global growth has perked up, with the Markit global composite purchasing manufacturer’s index hitting a 3-year high of around 54.3 last week. A figure of more than 50 indicates an expansion of private-sector activity. The boost to industrial activity has strengthened demand for commodities, a mainstay for developing-market economies.
Moreover, a weaker dollar has allowed bond investors to reap the additional gains of strengthening domestic currencies, juicing their returns.
But emerging market investors might be feeling remorse at the end of the year if the Federal Reserve tightens monetary policy beyond its own projections for three hikes in 2018.
In a worst-case scenario, tighter monetary policy could spur the dollar’s rebound and hasten investors’ flight out of emerging markets as the difference between interest rates in emerging markets and the U.S. narrow, said analysts at Fitch Ratings.
A stronger greenback could leave corporate issuers in these far-flung nations struggling to pay their dollar-denominated debts if their profits come from local currencies.