Article / 11 January 2017 at 11:00 GMT

Weekly Bond Update: EM healthy despite rising yields – #SaxoStrats

Fixed Income trader / Saxo Bank
Denmark
  • With rates rising, US-denominated emerging market debt will be hard to service  
  • Commodity-dependent nations will be first in line to feel the pressure 
  • But the reality may be that higher global growth will offset higher interest rates 

By Michael Boye

The threat of dramatically increasing interest rates primarily in the US has been latent for years, but for one sector its reality has serious repercussions – emerging markets, where USD denominated debt still constitutes a significant share of both corporate and government financing.
Emerging market bonds have long been driven by two major supportive long-term forces; namely improving economic and market fundamentals as well as record low (and in some cases negative) yields across the developed world.

It has forced global investors to focus on (higher) yielding alternatives. Now that US interest rates are widely expected to rise, the narrative is that this debt would obviously become much more difficult to service.

Furthermore, investors have been worried that if the rise in yields were to puncture the global economic recovery, the commodity-dependent developing nations be first in line to feel the pressure, along with potential turmoil in financial markets globally, which could add insult to injury as investors flee the region and withdraw investments.

hot air balloon

Trump's fiscal boost could actually reflate commodity-dependent economies. Photo: iStock

Just when you thought the outlook couldn't be more gloomy, Donald Trump was elected as the next president of the United States. Among his promises (or threats depending on your perspective) is the protectionist anti-free trade agenda which aims to take back jobs from the emerging economies.

Emerging Market 5-year generic bond yield. Computed as the 5-year generic US treasury yield with addition of the Markit CDX Emerging Markets Index spread.
bonds

Source: Saxo Bank and Bloomberg

The election did cause the market to sell off late in 2016, when in November investor cash inflow to emerging market bond funds regressed for the first time four months. However, so far this year, while the theme of rising interest rates has persisted in both the US and Europe, these bond markets have performed surprisingly solidly.

There are several more reasons that this makes sense and that the optimism could actually be sustainable going forward as well. First of all, the exact policies of the new administration are still a work in progress – and quite possibly subject to change along the way.

It may not be all bad news, as the promised fiscal stimulus boost from the incoming Trump administration, that has set the market on fire the past couple of months, could actually also secure an additional boost for commodity exporters, where prices have been ticking upwards recently.

Secondly, while record low or negative yields might soon be a thing of the past, the upturn in global growth (which is the very reason rates are on the move) could possibly more than make up for the adverse effects. In this case, the higher carry (yield premium) would enable investors to more quickly recover from the potential temporary loss of rising interest rates, while the credit spread of corporate bonds might even tighten as a consequence of stronger economic performance and further offset the headwind of rising interest rates.

Finally, at this point, with the markets looking for at least two and possibly three additional rate hikes from the Federal Reserve this year and the 2-year US Treasury bond trading with its highest yield since 2009, investors are bracing for things to change already and higher interest rates seem well versed. And as we know, a watched pot never boils.

– Edited by Adam Courtenay

Michael Boye is a fixed income trader at Saxo Bank

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