And it corresponds to a new investment theme that has emerged over the last few months: The central banks of some emerging market countries indicated that they would either pause or end their monetary easing, even as inflation expectations continue to decline. Meanwhile, actual inflation among emerging markets has declined at a greater clip than central banks have been cutting their interest rates, leading to a rise in real yields1 and a steepening of yield curves.
As a result of steeper curves, longer-maturity bonds now pay a higher risk premium in the form of higher yields. We are taking the opportunity to tap this premium by increasing the duration of our locally denominated bond holdings in some markets for the following reasons:
- We believe the current valuations—and hence the risk/return profiles—of those bonds are attractive.
- Given the financial reforms going on in some of the countries in which we invest, we expect real interest rates2 to come down—rather than go up—over time. A decline in real rates would result in the price appreciation of bonds and hence in capital gains.
- Even if interest rates do rise, we expect carry (the interest rate we receive from an emerging market bond minus the rate we pay for short-term borrowing) and roll-down (the change in the bond’s price over a certain period given the current shape of the yield curve) to provide sufficient cushion against potential losses.
Specifically, in Brazil, Russia, South Africa and India, we have rolled our positions on the front end of the yield curve (i.e., our shorter-maturity positions) to longer tenors (or longer-maturity positions) while remaining overweight in those positions. In Hungary, we switched our front-end positions to the middle of the yield curve because of its central bank’s continued effort to flatten the curve—and we hold a neutral view on duration given the country’s low real interest rates.
Let’s take a closer look at the rationale for our outlook and portfolio positioning.
We Think Bond Valuations Remain Attractive
Real yields in the countries just mentioned remain extremely high, with the exception of Hungary (Exhibit 1). We believe that even if inflation rises—as the capital markets expect in some countries—the high real interest rates (and thus high real yields) in Brazil, India, Russia and South Africa will provide a cushion against potential losses. High real yields also suggest that the monetary policy of these countries has been tight. And because emerging markets appear to be at a less mature stage of the business cycle than the United States—and developed economies in general—we believe that emerging economies are currently less prone to surprise us with inflation.
Structural Factors May Lower Real Yields Over Time
The economic adjustment forced upon many emerging markets since the “Taper Tantrum” of 20133 and subsequent commodity crisis of 20154 eventually led to weaker currencies and higher nominal interest rates throughout the period of 2013-2015. On the back of tight monetary policy in those markets, inflation has been dropping faster than central banks have been cutting rates. Therefore, real rates have stayed high and in some cases have been increasing. It is our view that some central banks may continue to lower rates and be accommodative for some time—or remain on hold for a while and allow inflation to pick up.
And there are other structural factors at play. Brazil and India, for example, have begun to enact financial reforms, which we expect will help lower real yields over the medium term. For example, in 2016, Brazil passed a constitutional amendment imposing limits on government spending. The country’s pension reforms still remain on the reform agenda’s highest priority and most likely will be addressed in 2019.
India’s government has also initiated significant structural reforms, including the passing of the Goods and Services Tax (GST) bill in 2017, which streamlined and simplified the country’s complex tax code, and should benefit businesses. Further, the improvement of India’s ranking by the World Bank as an easier place to do business—and the country’s effort to address the non-performing loans of its banks—are indicators of a more sustainable growth path ahead, in our opinion.
With regards to South Africa, we recently published our political, economic and investment views following the election of Cyril Ramaphosa as the country’s president. We are more optimistic about reforms and expect the risk premium in South Africa’s sovereign yield curve to come down over the coming period. Since we published our views, Nhlanhla Nene was appointed Finance Minister and Pravin Gordhan was appointed Minister of Public Enterprises. These appointments increase our confidence in the restoration of their respective institutions’ credibility.
An Opportunity for Active Investors to Tap Yield Curves
As inflation declined in most emerging markets over the last two years, central banks have taken the opportunity to ease monetary policy in order to stimulate growth. Over the last few weeks, as earlier mentioned, the capital markets have priced in a pause in the easing cycle of some countries, and priced in an end to the easing cycle in others. This shift has led to a steepening of yield curves in several countries to nearly the same degree as witnessed during the Taper Tantrum of 2013 (Exhibit 2).
Yield curves can steepen as a result of multiple reasons, including but not limited to the following:
- market expectations of higher inflation;
- a risk of fiscal slippage (which occurs when a government’s expenditures surpass their expected or estimated levels); or
- a steepening of yield curves in “core” markets5 (such as the United States and Europe).
As Exhibit 3 shows, yield curves in the United States and Europe are much flatter than they were in 2013. Therefore, we believe that the risk premium embedded in the yield curves of emerging markets, which has caused them to steepen, is a result of market expectations of higher inflation, as well as idiosyncratic factors.
What are those idiosyncratic factors? For example, South Africa’s yield curve has been steepening since the election of Jacob Zuma as President in 2009. The subsequent deterioration in the country’s credit quality led to a repricing of fixed income, and the spread between 5-year bonds and 30-year bonds widened to reflect an extra risk premium for Mr. Zuma’s 9-year tenure. On average, that spread traded roughly 150 basis points above the 10-year average in the decade prior to Mr. Zuma’s presidency. In light of our view we expect this premium to decline and settle into a lower range similar to that of the pre-Zuma period (Exhibit 4).
Shifting Toward the Steepest Part of the Yield Curve May Enhance Our Portfolio’s Carry Profile
We follow a consistent and thorough process in an effort to identify the best bond maturities along the yield curve and maximize returns for our risk exposure to a given country. In order to achieve that objective, we aim to identify the tenor (or the maturity point along the curve) that offers the best carry and roll-down.
Exhibit 5 features one example: After one year—and assuming the yield curve remains static—a 6-year Indian bond yielding 7.79% becomes a 5-year bond yielding 7.52%. Such a bond is said to offer a roll-down of 27 basis points over one year—essentially the difference between the two yields.
We aim to identify the tenors along the curve that maximize the carry and roll-down and thus extract the highest premium. For example, in the case of Brazil, one could potentially achieve a carry and roll-down of 118 basis points annually—an improvement of 130 basis points—by rolling one’s position from a tenor of one year to three years—and then holding on to that position for a year.6 Similarly, one could conduct such a trade along South Africa’s yield curve to potentially extract a premium by rolling one’s position from a tenor of 2 years to 10 years.7
Exhibit 6 features additional examples of similar trades along the yield curves of select countries—Russia, Hungary, India, South Africa and Brazil—and the annualized carry and roll-down (in basis points) that an investor could extract. For example, if on February 28, 2018, you bought a 2-year Russian sovereign bond, you might achieve an annualized carry and roll-down of 12 basis points, with the assumption that interest rates remain the same throughout the year. Yet a shift toward a 5-year bond would potentially produce 24 basis points for the year with the same assumption—a possible improvement of 12 basis points by shifting toward the back end of the curve.8
Conclusion: Emerging Markets and the Yield Curve
Real rates in select emerging markets are higher as a result of actual inflation coming down at a greater clip than central banks have cut interest rates. As a result, we are actively managing our positions along the yield curves of those markets. In so doing, we seek to optimize our risk allocation in each country—and, in some cases, monetize the newfound premiums of longer-maturity bonds by increasing our allocations to them.
We remain overweight in countries we deem most compelling in terms of security valuations and prospects for financial reform.
- ^The real yield of a bond is calculated by subtracting the inflation rate from the nominal interest rate of a bond, and then dividing it by the bond’s price. Essentially, it’s the difference between a bond’s nominal yield and the current rate of inflation.
- ^The real interest rate is the nominal rate minus the rate of inflation.
- ^The “Taper Tantrum” refers to the surge in U.S. Treasury yields in 2013, which resulted from the U.S. Federal Reserve’s use of tapering to gradually reduce the amount of money it was feeding into the economy.
- ^In 2015, the prices of a range of commodities—from crude oil to industrial metals—plummeted.
- ^Core markets are the world’s largest and most influential economies.
- ^Source: Bloomberg and OppenheimerFunds, as of 2/28/18.
- ^Source: Bloomberg and OppenheimerFunds, as of 2/28/18.
- ^Source: Bloomberg and OppenheimerFunds, as of 2/28/18.
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future, will cause the values of a portfolio’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at or near historic lows. When interest rates rise, bond prices generally fall, and the value of the portfolio can fall. Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Investments in a single issuer may increase volatility and exposure to risks associated with a single issuer. Derivative instruments entail higher volatility and risk of loss compared to traditional stock or bond investments.
The mention of specific countries, securities issuers or sectors does not constitute a recommendation on behalf of OFI Global.
OppenheimerFunds is not undertaking to provide impartial investment advice or to provide advice in a fiduciary capacity.