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In the ongoing search for yield, you might have noticed that emerging market debt has begun to look intriguing as bond prices tumble and local currencies weaken. The word from UBS: Don't be fooled, emerging market debt has further to fall.
Last year was a bad one for investors in this area of the market, and the slump has stretched into 2014 as well. According to Bhanu Baweja, a UBS strategist, the average yield for 10-year bonds has risen to about 7 per cent from below 6 per cent at the start of 2013 (as yields rise, bond prices fall).
The spread over U.S. 10-year Treasuries is an attractive 4 percentage points before inflation and 2 percentage points after inflation, which looks like an attractive premium.
Similarly, exchange-traded funds that provide easy exposure to emerging market debt have seen unit prices fall close to five-year lows. The Western Asset Emerging Markets Income Fund has fallen more than 17 per cent over the past year, sending the yield above 8 per cent (based on trailing 12-month payouts).
In an era when Canadian government bonds yield next to nothing and equity dividend yields are generally low, emerging market debt looks like a rare opportunity to score some income.
But Mr. Baweja argues that while emerging markets have adjusted, the bonds still aren't cheap. For one thing, the yield spread over U.S. Treasuries only looks attractive if you ignore the credit worthiness of emerging markets. You shouldn't: The ability and willingness of some countries to service their debt is worsening, at least according to the market (or credit default swaps).
"We can theoretically think of real rates in EM as real rates in the U.S. plus a credit risk premium," Mr Baweja said in a note. "Once we adjust for inflation differentials and changes in creditworthiness, we find that EM rates (at a broad benchmark level) have simply adjusted in line with U.S. rates."
In other words, it's hard to see emerging bonds as a steal right now, especially if U.S. bond yields continue to rise and other bond yields rise with them.
The UBS economics team expects the yield on the U.S. 10-year Treasury bond will rise to 3.5 per cent by the end of this year, up from 2.8 per cent right now – and then rise to 4 per cent by the end of 2015. As a result, emerging market bond yields should rise by another 70 to 100 basis points (or up to 1 percentage point) this year, as credit spreads widen, implying a loss of 3.5 per cent to 4.5 per cent on the price of emerging market bonds.
That could be painful if money that had flowed into emerging markets in recent years starts to reverse.
"Flows into emerging fixed income markets will at best thin out, and at worst could be subject to a big withdrawal," Mr. Baweja said. "This is an important consideration given how dependent EM capital accounts are on debt flows."
David Berman