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Proper Preparation For an EM Bond Rebound

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Things were not supposed to be this way for emerging markets bonds in 2018. Last year, the J.P. Morgan EMBI Global Core Index returned 10.30 percent and heading into 2018, it was widely expected to emerging markets central banks, excluding Mexico’s, would hold off on raising interest rates.

What was expected for emerging markets bonds at the start of 2018 and this year’s realities for the asset class are two entirely different matters. Weakness in emerging markets currencies at the hands of the stronger U.S. dollar exposed fragile external finances from Argentina to Turkey, leading to a spate of unexpected and to this point, ineffective interest rate increases.

One response to the glum environment for emerging market bonds is a reduction in issuance. During the third quarter, developing economies issued $358.7 billion in corporate and government bonds, a 25% year-over-year decline and the first decrease in issuance in three years.

Clearly, these are trying times for emerging markets bonds, but that does not mean the asset class should be permanently discarded. Fixed income investors willing to consider the rebound of potential of these embattled bonds should be selective and consider alternatively-weighted strategies. That includes the JPMorgan USD Emerging Markets Sovereign Bond ETF (JPMB).

JPMB Details

Debuting in late January, the JPMorgan USD Emerging Markets Sovereign Bond ETF (JPMB) may be battling inauspicious timing more than anything else this year. As the chart below indicates, JPMB, since inception, has been less bad than some rival strategies.

JPMB targets the JPMorgan Emerging Markets Risk-Aware Bond Index, an offshoot of the widely followed J.P. Morgan Emerging Market Bond Index Global Diversified. The traditional weighting methodology for bond benchmarks, including emerging markets products, is cap weighting (issuer size), but the JPMorgan Emerging Markets Risk-Aware Bond Index employs a proprietary, rules-based methodology that screens for liquidity, country risk and allocates based on credit ratings.

Countries with high spread risk are not included in JPMB’s lineup. Only issues with a current face value of $1 billion or more outstanding make the cut.

Related: Factor Views 4Q18

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Geographic Attribution

With any international strategy, equity-based, fixed income or otherwise, geographic attribution is a paramount consideration. That is particularly true at a time when a slew of emerging markets are home to rising sovereign debt yields, meaning prices of those bonds are sinking.

As the chart below shows, the JPMorgan USD Emerging Markets Sovereign Bond ETF (JPMB) is overweight Turkish bonds relative to its benchmark and the category average, underscoring the point that the fund’s “less bad” performance is impressive when considering Turkey’s scorched earth campaign of raising interest rates.

COURTESY: MORNINGSTAR

Brazil, Latin America’s largest economy and JPMB’s second-largest geographic exposure, has been cutting interest rates. Markets were pricing in victory for far-right, pro-markets lawmaker Jair Bolsonaro in the Oct. 28 runoff election there and that result was realized. Yields on Brazil’s benchmark 10-year bonds fell slightly on Oct. 26, the last trading day before the election, and are down about 200 basis points over the past six weeks, a period in which Bolsonaro increased his lead in polls.

What’s Next

Forecasting exactly when emerging markets bonds will turn for the better is a difficult task, but some market observers believe that could happen late this year or next year, if and when the U.S. and China resolve their trade dispute.

The JPMorgan USD Emerging Markets Sovereign Bond ETF’s (JPMB) alternatively-weighted positions investors for that rebound while delivering on the income front (30-day SEC yield of 5.96% as of Sept. 30). JPMB’s tilt toward higher quality debt potentially limits the fund’s vulnerability to a spike in default rates.

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