This is a sponsored article from State Street Global Advisors.

As the year end approaches, 2018 will be remembered as a challenging time for emerging market (EM) bonds. In particular, in recent months, global EM bonds have taken their turn in experiencing unsettling bouts of volatility, all driven by a number of macro developments. These include US rate hikes and a strong US dollar, tighter monetary policies globally, escalating trade tension and negative investment sentiment caused by events in Turkey and Argentina. These factors are seemingly unfavourable to investor interest in EM bond markets.

Outperforming EM peers
However, with closer scrutiny, despite the undeniable gravity of some issues facing certain emerging market economies, Asian bonds outperformed their EM peers’ performance on a year-to-date¹ basis when the markets are challenging by offering lower volatilities and better return/risk ratio. The attraction of investing in local currency debt is still apparent in Asia that remains relatively insulated from events occurring elsewhere.

While investor risk appetite had a clearer direction in 2017, it has consequently alternated between risk-on and risk-off in most of 2018. Investors have moved into cash as witnessed by an allocation to equity and fixed income, coupled with a multi-asset funds decrease and allocation to money market funds increase year-to-date.

Risks remain
In our view, US dollar movements and volatility will remain the key risks for EM bonds in the near term. The US dollar is likely to be underpinned by further monetary tightening from the US Federal Reserve reiterated by an additional rate hike expected in December and another three to four increases anticipated in 2019.

While we expect the current period of quantitative tightening to run for some time – especially given Europe, Japan, and the UK are so far behind the US in their progression towards tighter conditions – we do expect interest rates to peak at a far lower level than in previous cycles. This entails the higher yields on offer in Asian market debt can remain relatively attractive.

Other risks include those posed by countries such as the Philippines, Turkey, and Argentina. These will not simply vanish overnight. And there remains the escalating global trade dispute between the US and China. That said, the recent agreement on a new version of NAFTA between the US, Canada and Mexico offers some cause for optimism.

Long-term story stays intact
In the past, shake-outs in EM bond and equity markets have been short and sharp, followed by a long and gradual recovery. In a rush for the exit, indiscriminate selling has typically pushed entire markets down – particularly evident in EM bonds due to a perception of higher risk. This, in turn, has created opportunities for the vigilant long-term investor.

After all, the fundamentals of the EM story remain mostly unchanged. In particular, for Asia, strong secular economic growth rates, favourable demographics, better fiscal positions and improving credit ratings continue apace.

For shrewd investors prepared to take a longer-term view, the recent upheavals may present an opportunity. Emerging market currencies appear undervalued against the US dollar, and yield spreads have spiked higher, offering an attractive entry point.

In perspective, consider that following the global financial crisis, very few had the nerve to invest in emerging market bonds, but those who did were richly rewarded.

Within the emerging market debt universe, Asian local currency bonds are certainly more stable than those of some of their Latin American counterparts, for example, and carry many of the same attractions but fewer of the risks. Asian economies are now more rigorously monitored, and less vulnerable to the disruptive forces of the past. Economic growth and reforms have produced better-functioning markets that, importantly, are now less reliant on overseas investors to fund deficits.

Investors in emerging market debt have a choice of hard or local currencies. Some have expressed concern over foreign exchange that “the biggest uncertainty in the local currency space is currency”. However, historically, currencies have been a significant contributor to Asian local currency bond returns, as represented by the iBoxx ABF Pan Asia Index, with annualised currency returns since January 2001 having contributed 1.61% to the total Asian local currency bond return². In our view, local currency investment may offer the potential to fully benefit from growing Asian economies by capturing both the bond market returns and currency gains.

Visit www.abf-paif.com* for our latest insights and investment ideas for Asian fixed income.

This is a sponsored article from State Street Global Advisors.