“With credit spreads still tight, consider moving into the safer parts of the credit spectrum and focus on shorter maturities. After recent price declines, we believe that EM corporate bonds are attractive again..””
– Eli Lee, Head of Investment Strategy, Bank of Singapore, Member of OCBC Wealth Panel
Emerging Market (EM) bond performance ended the month under pressure, as bad news effectively weighed on good, and the positive returns initially realised at the beginning of October were progressively eroded, despite a rally in US Treasuries and positive developments in Brazil and Turkey.
Turkey’s relief rally, following the release of American pastor, Andrew Brunson, and the ascendancy of Jair Bolsonaro, a more market-friendly candidate to the Brazilian presidency, were overshadowed by, among other things, the release of weak economic data in China and negative investor sentiment towards Mexico in the lead up to – and following – the unfavourable outcome of the Mexico City Airport
Overweight EM High Yield bonds
Bond spreads widened across all EM bond classes in October, with EM High Yield (HY) bond valuations remaining more attractive, relative to both EM Investment Grade (IG) and US High Yield spreads.
We continue to recommend an overweight position in EM HY bonds. More attractive valuations of EM HY bonds vis-à-vis EM IG and US HY debt, coupled with modest default rates so far this year, continue to underpin our constructive view of EM HY.
Despite our constructive view on EM bonds, we reiterate our message from previous quarters urging investors to stay defensively positioned in EM credit by maintaining moderate exposure to the low end of the credit spectrum and remaining underweight duration, to moderate the impact of rising interest rates on bond performance, with further US interest rate hikes still on the cards.
IG bonds continue to face challenges
The challenges facing IG credit did not abate through October. Spreads were wider in Europe as well as the USA. The turmoil in equity markets was only a part of the explanation.
The European situation is not being helped by the issues facing Italy. There are more than enough banks that are still nursing painful memories of exposures to Greece and generally the fallout from a prolonged period of slow grow in earnings in the Eurozone.
In the US, there is a noticeable trend going on in new issuance. As is quite typical of late cycles, the quality of issuance as measured by credit quality is deteriorating. A greater number of BBB-rated issuers are coming to market with new bonds compared to higher-rated issuers.
IG bonds to provide muted returns
The house view for economic growth is that there will not be a recession in the US in 2019. Recessions are uniformly bad news for credit. It impairs the ability of firms to pay back principal and interest and dims the appetite of investors for new issuance. The latter makes it harder for firms to re-finance existing debt. Without these dynamics in place for the immediate future, the returns on IG will be driven at the margin by issuance volume and developments in the treasury market (base interest rates) more than a perception that the macro environment is too negative.
The outlook for returns in IG remains muted. It can sometimes be the case that a weak year is followed by a much stronger one. At present, we feel that the low level of outright yield combined with the further upside scope in spreads constrains the outlook for IG.
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