Should emerging debt investors be afraid of the Fed’s hike cycle?

In March 2022, the Fed raised the federal funds rate for the first time since 2018, raising rates by 25 basis points. This was followed by a 50 basis point hike in May, another 75 basis points in June and 75 basis points in July. Combined, the rate hikes pushed the federal funds rate from 0.25% to 2.25%-2.50% – the first time it has reached this level since 2020, writes Daniel Wood of William Blair Investment Management .

The rises weighed on emerging market debt yields, which were already low in 2021 and the first quarter of 2022, due to investor fears about the impact of the war in Ukraine and Chinese shutdowns.

The speed and extent of further monetary tightening is uncertain and, therefore, there are concerns about the impact of rate hikes on future fixed income yields. Should investors be concerned or could this be a buying opportunity?

There are three main components of EM debt returns: the starting yield of the asset class; changes in emerging debt spreads; and the sensitivity of returns to changes in US Treasury yields.

Currently, a number of fears are raising concerns about future emerging market sovereign debt yields:

  • – Emerging debt sensitivity to rising interest rates could hurt performance
  • – Emerging market debt spreads could widen as interest rate hikes hurt global growth
  • – Outflows could accelerate as fixed income securities and risky assets become less attractive
  • – The US dollar could strengthen as interest rate differentials between emerging and developed markets narrow
  • – Rate hikes could reduce liquidity and accelerate emerging market debt restructurings

Increased duration and sensitivity

The argument that rising interest rates – and rising Treasury yields – will hurt emerging market debt yields is particularly relevant today, as the duration of emerging market hard currency debt has increased over the past 20 years as sovereign issuers managed to extend the maturity of their dollar issues. In short, the duration of emerging market debt is longer today than it was in previous Fed tightening cycles.

So, in theory, the sensitivity of emerging market debt to rising Treasury yields is higher today than in previous Fed tightening cycles, so we have to ask ourselves if that should be a concern. for investors – and the answer is that there is little historical evidence to suggest that Treasury yields will rise significantly once the Fed’s rate hike cycle begins.

Based on the three previous rate hike cycles, we believe there is little evidence that the 10-year US Treasury bond yield will rise significantly in the year following the Fed’s first hike of the cycle. current, taking us to March 2023.

In each of the past rate hike cycles, EM high yield debt has outperformed EM investment grade debt in the 12 months following the Fed’s first rate hike. We expect the current tightening cycle to be no different. The high yield/investment grade spread differential is trading at historically wide levels.

We therefore believe it may be imperative to overweight the high yield sector at the expense of investment grade bonds which offer less probability-weighted upside potential and seek to take advantage of distressed credit valuations.

Unlike the previous three bull cycles, we recognize that inflation is much higher this time around, but believe it is largely due to supply-side disruptions rather than an overheated economy and strong domestic demand.

Therefore, we think we could be close to the peak of inflation. A combination of positive base effects and potential solutions to supply-side disruptions could allay some current fears about where inflation and the fed funds rate might go.

Bloom off fixed income rose?

Another concern that is raising concerns about future emerging market sovereign debt yields is that capital outflows could accelerate as fixed-income securities and risky assets become less attractive. The perception persists that as rates rise, fixed income investments, especially those with longer durations, become less attractive. This, according to common wisdom, leads to a cycle of exits and underperformance.

During the 2015-2018 rate hike cycle, inflows were solid. Assets under management relative to emerging market hard currency benchmarks actually increased by around 20% on strong capital inflows without any period of appreciable negative drawdown. Assets then grew another 10% in the year following the first rate hike (2016).

In recent years, flows to dedicated hard-currency bond funds from emerging markets have been positive despite Covid-19 headwinds. This year was the exception, with net outflows of a reasonable magnitude as global liquidity conditions tightened.

However, we expect that as valuations continue to improve, flows will return to the asset class, which could act as a catalyst for higher prices.

We believe that only a very bearish set of circumstances is likely to generate negative returns for emerging market investors over the next year. Our analysis suggests that it would likely take a combination of the rising 10-year US Treasury yield and the substantial widening of emerging market debt spreads for the asset class to generate a negative return.

As such, we now believe EM debt may represent a buying opportunity for investors looking to take advantage of higher yields and improved valuations. Of course, in the current environment, nothing is certain. We remain focused on managing risk and changing market conditions to identify attractive investment opportunities.

This article was written for the Portfolio Adviser by Daniel Wood, Portfolio Manager, Emerging Markets Debt, William Blair Investment Management

Carol M. Barragan