Big emerging market bond managers, including Aegon USA Investment Management and JPMorgan Asset Management, are reducing their exposure to the riskiest positions in dollar-denominated developing-world debt. This shift comes as spreads on these bonds have tightened to just 170 basis points over Treasuries, their narrowest since 2007, even as investors anticipate higher interest rates for longer. Over the past year, dollar bonds from developing countries returned 1.4%, but this resilience has made some investors uneasy, especially with Treasury yields at nearly 20-year highs and oil above $100 per barrel.
Fund managers are pivoting to stronger credits and local-currency debt. For example, Jeff Grills of Aegon has reduced exposure to Colombia while increasing holdings in higher-rated countries such as Indonesia, Saudi Arabia, and the Philippines. Gorky Urquieta of Neuberger Berman has scaled back high-yield names like Ecuador, the Dominican Republic, and Zambia, stating a "retrenchment mode." Similarly, Matt Graves at PPM America has increased duration in higher-rated issuers like Morocco while cutting riskier positions such as Angola. Local-currency emerging market bonds have seen a 0.9% gain this year, outperforming developed world stocks which are up over 23%.
This increased caution is also reflected in fund flows, with the largest exchange-traded fund tracking emerging market hard currency bonds experiencing some of its biggest single-day withdrawals since March. Investors are concerned that tight valuations, combined with surging Treasury yields, leave little buffer for emerging market credit to absorb further global rate shocks without experiencing wider spreads. Bloomberg Intelligence identifies US monetary policy as a key risk for hard-currency emerging market debt in the fourth quarter, with narrow spreads potentially amplifying the impact of country-specific bond issues.
Some managers are finding opportunities in investment-grade bonds that have been hit by the Treasury selloff. Fernando Grisales of Schroders has added debt from Saudi Aramco and Mexico. Pierre-Yves Bareau of JPMorgan Asset Management has reduced the portfolio's sensitivity to a credit selloff, reallocating risk towards local-currency bonds, including those from Mexico, where he believes swap markets are overestimating rate hikes. The consensus among managers is a move towards higher credit quality and local markets, expecting portfolios to emphasize sturdier names and local bonds until valuations rebuild a safety margin.
