Emerging debt vs equity: to rotate or not
Emerging bonds have got off to a flying start in 2013, with debt funds taking in over $2 billion this past week, the second highest weekly inflow ever, according to fund tracker EPFR Global. Issuance is strong – Turkey for instance this week borrowed cash repayable in 10 years for just 3.47 percent, its lowest yield ever in the dollar market.
Yet not everyone is optimistic and most analysts see last year’s returns of 16-18 percent EM debt returns as out of reach. The consensus instead seems to be for 5-8 percent as tight spreads and low yields leave little room for further rallies — average yields on the EMBI Global sovereign debt index is just 4.4 percent. Domestic bonds meanwhile could suffer if inflation turns problematic. (see here for our story on emerging bond sales and returns).
Now take a look at U.S. Treasury yields which are near 8-month highs. and could pose a headwind for emerging debt. Higher U.S. yields are not necessarily a bad thing for emerging markets provided the rise is down to a healthier economic outlook. But that scenario could induce investors to turn their attention to equities and indeed this is already happening. EPFR data shows emerging equity funds outstripped their bond counterparts last week, taking in $7.45 billion, the highest ever weekly inflow.
Last year emerging stocks rose 15 percent, even though companies’ earnings were mostly flat. Analysts at Citi reckon MSCI’s emerging equities could provide total returns of 12 percent in 2013, especially if growth in the developing world continues to look up and corporate earnings pick up.
Equities, unlike emerging bonds, also look fairly cheap, trading (according to Citi) at 18 times trend earnings on a cyclically adjusted basis — a quarter cheaper than the long-term average. Citi analysts calculate the trailing yield on MSCI’s emerging equity index at 7.9 percent, versus 3.3 percent on emerging bonds weighted to the MSCI index. They write:
The valuation case for EM equities remains very powerful versus EM bonds and may now, finally, be starting to have some effect on asset allocation
decisions. The long-term incentive for investors to rotate from EM bonds into equities, which is something that we recommend, remains compelling.
Barclays too reckons a move to equities seems appropriate but it also believes it is too early to call the end of the emerging debt boom. At least for now, the large flows to EM equity funds suggest a risk appetite pick up rather than rotation out of fixed income assets and into equities, Barclays argues.