Difference in borrowing costs between developed and emerging markets is lowest in 16 years – 07/12/2023 – Market

The gap in government borrowing costs between emerging and developed markets has fallen to its lowest level since 2007, as investors price in looming interest rate cuts in some major emerging economies and further tightening in the West.

The spread this week has fallen to less than 2.9 percentage points, the lowest in 16 years, from 4.8 points a year ago, according to data from Allianz Global Investors.

“There has been a huge divergence between local currency debt in emerging markets and developed markets this year,” said Richard House, chief investment officer for emerging market debt at Allianz Global Investors.

“Investors are recognizing the narrowing of the credibility gap between policymakers […] Emerging markets have done a good job of dealing with this inflationary shock, and I’m not sure you could say the same for some of the western central banks.”

Central banks in Latin America and Eastern Europe – regions that are home to the world’s best-performing bond markets this year – moved more quickly to raise rates in response to inflationary pressures as economies reopened after restrictions in the coronavirus pandemic.

JPMorgan’s widely followed benchmark index of emerging market local currency government bonds has returned a total of 7.5% year-to-date, driven by the Latin America sub-index, which rose 21%, and Central and Eastern Europe , which gained 11%.

In contrast, US government bonds have generated total returns of just 1.6% this year, as measured by the ICE Bank of America government bond index, while German bonds – the de facto benchmark for the euro zone – have generated total returns of 1.2%.

Given the still high real yields offered on emerging market debt, falling inflation and the prospect of rate cuts that should boost bond prices, many investors are positioning themselves for further gains.

“Rates and local currency bonds present a very attractive opportunity for the next six months and beyond,” said Liam Spillane, head of emerging markets debt at Aviva Investors, highlighting Mexico, Peru, South Africa, Czech Republic and Poland , where he believes markets have underestimated the potential for rate cuts.

Iain Stealey, director of international fixed income investments at JPMorgan Asset Management, said he expected emerging market local currency bonds “to continue to do well given high real rates and central banks that are generally weary of the ups and downs of inflation”.

“Our preference is for countries with high real rates like Brazil, Mexico and Indonesia, as well as countries where we expect inflation to drop sharply, like the Czech Republic,” he added.

Economic prospects in the developing world also look relatively strong. In a recent note to clients, Bank of America forecast that emerging economies will grow by an average of 4.1% in 2024, compared with 0.5% growth in the US, which would be the biggest growth differential in a decade.

Local currency debt performance reflects the relative resilience of some of the larger emerging economies, which typically have deep local bond markets. Smaller and less developed emerging markets, which rely more heavily on foreign currency borrowing, have struggled this year as rising bond yields in the West overshadow the attraction of their dollar-denominated debt.

Higher US interest rates have pushed some countries that rely on dollar-denominated debt, including Pakistan, Tunisia and Egypt, into debt stress and closer to default, according to David Hauner, head of strategy and economics at cross-assets at Bank of America Emerging Markets.

“You have a very positive story that benefits conventional and more liquid markets and at the same time there is a quiet debt crisis in frontier markets,” Hauner said.

Translated by Luiz Roberto Gonçalves