Emerging market debt could serve as a protection against rising US yields
Since the Covid-19 pandemic, easy monetary conditions caused an unstoppable rally and surge of negative-yielding debt. Spanish 10-year sovereigns last week were the latest to join the $18 trillions pile of sub-zero yielding debt, putting more pressure on investors that need to put money at work. Negative yields have been one of the reasons why investors started to look beyond their borders.
Initially, the market has been selective and picked only higher-rated EM paper which widened amid the coronavirus pandemic. Still, afterwards, investors ended up buying junk EM debt pushing yields lower and lower.
Spread compression this year has been substantial in both EM credits. On average, EM bonds are now offering the lowest yield in history. The Bloomberg Barclays emerging markets hard currency index indicates than on average EM US dollar sovereign bonds offer around 3.5% in yield. Such conservative yield doesn’t deter investors from buying these securities, because what they look at is real yields. US 10-year real yields are now quoting at around -1% while Emerging real rates are much higher, giving investors a significant buffer against US rising yields.
Moreover, let's look at the option-adjusted spread that EM bonds offer over the US Treasuries. We will find that it is still wider than pre-global financial crisis historic lows. Therefore there is plenty of space for more tightening even if yields touched a historic low. Investors will continue to see upside holding EM debt, especially in light of soaring US rates.