Search for yield leads to positive 2013 outlook on emerging market debt, says Western Asset

Robert Abad, emerging markets portfolio manager at Legg Mason subsidiary Western Asset Management, has said that continued hunger for yield among investors should make 2013 a good year for emerging market debt.

“With global central banks committed to keeping interest rates low, increased demand for higher yielding assets has pushed record levels of capital into EM debt, driving sovereign and corporate yields toward historic lows,” he said.

Abad highlights the growing high yield EM sector, which includes corporate borrowers as well as lower-rated sovereigns such as Argentina, Ukraine and Venezuela, and frontier markets including Sri Lanka, Mongolia and Belize.

“The prospect of greater demand for EM high yield is clear. The rapid expansion of the asset class over the past few years has occurred as traditional drivers of return – external sovereign spread compression and rallying US Treasury yields – have largely run their course.”

“As a result, investors looking for income, plus diversification as US dollar spread product supply dries up.”

On the sovereign side, Abad said EM high yield offers an opportunity to play the improvement story from the beginning, with significant capital gains available as frontier markets move up to emerging status.

“From a corporate perspective, the expansion of the EM high-yield credit market has brought potential to find improving stories in the most stable of EM countries. This allows investors to take advantage of domestic economic trends and/or structural improvements, even as sovereign spreads trade at exceptionally tight levels.”

Abad said investors can get higher yields and significant spread pick-up via higher-quality EM high-yield corporates versus lower-rated US equivalents.

“The higher yields and shorter duration of EM high-yield credit also offers a considerable buffer against any rise in US interest rates should macro conditions stabilise earlier than anticipated or quantitative easing/growth-induced inflationary fears materialise.”

There is a note of caution, however. EM debt performance has been encouraged by strong global liquidity, which has enabled access to low-cost capital. “A protracted and technically fuelled issuer’s market can foster complacency,” said Abad.

Still, the balance sheet strength and policy flexibility in EMs should continue to support debt over equity, which Abad believes is vulnerable to market volatility and any potential weakening of global growth in the coming year.

 

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