As the developed world leveraged itself to the eyeballs over the years leading up to the financial crisis, emerging market countries were quietly applying lessons from their past economic crises, putting their financial houses in order. Still mindful of the debt crises of the past, many have built thriving economies, strong currencies and expanding middle-class consumer bases.
That discipline has led to a hot streak, not only in the stocks of these countries, but in their bonds. The J.P. Morgan Emerging Markets Bond Index returned nearly 12% in 2010, comparable with a lot of other strong fund categories.
"As we look at the 2010 performance of emerging market debt, it almost seemed that it did not matter which sector of the market you were invested," said Luz Padilla, portfolio manager of the DoubleLine Emerging Markets Fixed Income Fund, while speaking during a Webcast on February 8. "Whether you were in external sovereign corporate debt or local currency bonds, an investor would have earned low-double-digit returns for the year."
Knowing a good thing when they see it, investors have flooded into the space, hungry for yield and richer currency appreciation: According to tracker EPFR Global, emerging market bond funds drew in a net $53.6 billion in 2010. That's five times more than the year before, when it took in a net $9.5 billion. (The previous record was $9.7 billion in 2005.)
But then in early 2011, life got in the way. Just as soon as bond investors finished their banner year in the developing world, they woke up to find something else emerging: a cascade of popular uprisings and anti-authoritarian revolutions tearing through the oil rich Arab nations. Since the beginning of 2011, pro-democracy movements have fanned across Northern Africa from Tunisia, to Egypt, to Libya and kindled demonstrations in Iran, Kuwait, Algeria, Morocco, Iraq, Bahrain and Yemen. The turmoil has caused oil prices to spike and emerging markets to swoon.
The protests may seem to have condensed spontaneously from the pages of Facebook, but they in fact occurred against a backdrop of rising food prices and unemployment. Core food inflation has been bad for people in the streets, and it might prove to be bad for local bonds, too, causing interest rates to rise and bond prices to dip.
"I don't think [the revolts] would have happened necessarily, at least in this time frame and this quickly, if we didn't have the inflation problems," says George Strickland, co-manager of the Thornburg Strategic Income Fund. "If you look at the inflation indices in emerging market economies, in many cases more than 50% of their inflation index is food prices."
Meanwhile, the amount of money that's flowed into the space has some worried that yields have slunk, which means investors are getting similar rewards as they would in developed market bonds but taking bigger risks. Those worries, as well as the worries about core inflation might likely give some developing market bond fans pause and prompt them to hit the sidelines for now to rake off their profit.
"I think we've noticed over the past month or so that there's been a tendency to perhaps book gains from the strong performance that we've seen in the sector over the past two years," says Howard Booth, director and co-head of international fixed income at MacKay Shields. However, Booth, who oversees the MainStay Global High Income Fund, also says the fundamentals in the space are still strong.
Advocates cite low debt to GDP levels in emerging market countries, and insist that rising commodity prices (for copper, oil and iron ore) should buttress many emerging economies, especially as China continues to grow. EM bond cheerleaders also cite the increasing EBITDA margins of emerging market corporates and the rising number of investment-grade credits. In 2010, several sovereigns were upgraded by one or more of the rating agencies, some of them out of junk status. The upgrades include Panama, Costa Rica, Guatemala, Turkey, Indonesia, Morocco, Uruguay, Ukraine and the Dominican Republic.
"Over the long term, we are still very positive on the asset class and that's primarily because of fundamentals continuing to be positive," says Cristina Panait, a co-manager of Payden & Rygel's Payden Emerging Markets Bond fund. "We think that story hasn't really changed. Emerging markets are much better positioned than developed markets."