Back in 2022, we began alerting investors to an apparent regime shift in bond markets. Recent market events suggest this is much more than a fleeting move and that a fundamental shift is under way.
In recent years, the volatility of asset classes typically regarded as “risk free”, such as UK Gilts, German Bunds and US Treasuries, has shifted a gear. From a risk-return perspective, the distinctions between developed market (DM) and emerging-market (EM) bond markets have blurred – a process we call the “EMification of DM”.
While DM bonds have delivered lacklustre returns since 2022, their volatility has jumped. Meanwhile, volatility in many EM markets has stayed within historical ranges, while their total returns have remained resilient.
Furthermore, there have been episodes of bear steepening in DM yield curves, which reflect concerns around policy credibility – an unenviable phenomenon traditionally reserved for EM bond markets.
Three broad developments help illuminate this turning point:
Orthodox monetary policy in EMs
Despite the headwinds of relentless US dollar strength and the write-down of Russian local-currency debt in 2022, the EM debt asset class has shown resilience. This can largely be attributed to orthodox monetary policy in many EM economies, with EM central banks wasting no time raising interest rates promptly in response to growing inflation post Covid. In contrast, many DM central banks fell behind, deeming higher inflation to be “transitory”, which may have resulted in a faster and more pernicious rate-hiking cycle later.
Fiscal restraint in many EMs
In stark contrast to some DM peers, many EM economies have strengthened fiscal fundamentals over the past decade. The 2013 taper tantrum exposed underlying imbalances, prompting reforms by EM economies that boosted resilience. Even after the Covid shock, many EM policymakers remained fiscally prudent, with primary fiscal balances returning to surplus and debt-to-GDP stabilising at modest levels. Today, improved fiscal credibility is being recognised: EM ratings upgrades in 2024 outstripped downgrades, and more countries are on a positive than negative outlook, a reflection of more credible policymaking and fiscal reform.
Rising policy uncertainty in DMs
Terms like “political instability”, “rising populism” and “unsustainable public finances” – once reserved for EMs – have become increasingly common descriptions for some of the largest “developed” economies. Glaring fiscal imbalances and deteriorating macro fundamentals point to a less predictable policymaking backdrop in some “advanced” economies,
suggest the world order has been turned on its head and increasing the risk premium for investors.
Has DM debt lost its defensive properties?
The defensive role of DM debt has now been put to the test. Historically, downturns triggered by demand shocks – like the global financial crisis – meant falling growth and inflation, making fixed income a reliable buffer. But recent disruptions have been supply-driven: Brexit, Covid, Russia’s invasion of Ukraine and trade tariffs. These are exceptionally hard to quantify and have caused inflation to remain sticky even as growth slows, leading to higher correlations between defensive and cyclical assets. As a result, DM bonds have been less able to shield investors from equity
market losses.
Implications for asset allocators
All these shifts suggest DM debt markets should be viewed in a different light when considering portfolio allocations. The same applies to EM debt, where perceptions are often outdated. Much has changed since the “Brady bonds” of the late 1980s, when yields were sky high, liquidity scarce and
most debt dollar denominated. Credible monetary policy in EM economies has underpinned the development and significant growth of the EM local currency debt market, and the volatility of the benchmark has fallen with the inclusion of more Asian markets.
Furthermore, US dollar strength had cast a shadow over EM asset-class returns over the past decade. With this strength now arguably fading, the investment and inflation outlook is likely to mean a more even distribution of nominal growth across the globe. This should bring EM debt back onto asset allocators’ radars.
A different decade lies ahead
The new regime in bond markets suggests the case for portfolio diversification has never been stronger. Crucially, a “far and wide” approach may be needed. This is not just about picking winners; it’s about avoiding losers, especially in today’s geopolitical reality.
In the past, diversification was thought of in terms of regions, currencies and asset type (sovereign/credit and the like) but the changing role of interest rate risk and duration in portfolios is a vital consideration. All of this points to a more diversified global fixed-income portfolio, which includes EM debt and probably has somewhat shorter duration.
It is important to recognise the usefulness of EM debt as a diversifier, given the varied behaviour of individual asset classes across the cycle and the large dispersion across markets that sit within these.
A key benefit to investing across all EM debt asset classes is that the performance of each sub-asset class is differentiated through the broader economic and monetary policy cycle.
In summary, the old distinctions between EM and DM debt no longer hold and asset classes are unlikely to behave as they did historically. Asset allocation needs a reboot and EM debt – supported by an enduring, positive shift in fundamentals – deserves a seat at the global investor table.
Peter Kent is co-head of fixed income at Ninety One.
The full paper can be read here: Reframing fixed income: the
old rules are no longer fixed.
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