At an index level, the spread between local currency emerging market yields and global aggregate yields is back to pre-GFC levels. Does this mean that local currency spreads are too tight? Indices are too narrow and have a clear overweight to Asian local markets. Many of these markets have local yields below US treasuries.
Bond markets typically witness end-of-cycle volatility. The novel combination of monetary tightening and fiscal easing results in even more uncertainty. Supply worries, the Fitch downgrade of the US rating, higher energy prices, and a stronger than expected state of the US economy, have pushed 10-year US Treasuries yields firmly back above the 4.00% handle. In tandem, Latin American central banks have started easing with high real rates suggesting aggressive moves are possible. The combination of still peaking rates in developed markets and easing rates in emerging markets has helped narrow the spread differential considerably since its March 2022 peak.
At an index level, local currency emerging markets’ yields versus global aggregate yields are around 300bp, in line with pre-GFC levels. Local yields in some emerging markets are tight versus US treasuries relative to historical levels; in some countries – almost exclusively in Asia – local yields actually trade inside those of the US.
The composition of local currency indices diminishes their accuracy in representing the asset class. First, local currency indices are not well diversified as they typically contain a maximum of just 20 countries. Furthermore, the top 5 countries in these indices typically account for 50% of the overall indexi weighting and the top 10 countries generally account for 85%. Second, there is an overweight towards Asian countries with names from the region making up 40% of the JP Morgan GBI-EM and 52% of the Bloomberg Barclays local currency index. There has been a drastic change in the composition of indices lately, with the inclusion of China (at the maximum 10% weight), the exclusion of Russia (around 7.5% weight), and the collapse of Türkiyeii, which has resulted in a negative impact on the index yield. Index investors, over the last 10 years, lost between 15% and 20% as a result of defaults in combination with distressed countriesiii.
The chart below depicts the spread between the JP Morgan GBI-EM local currency index and the global aggregate index (blue) and the spread between an active, non-benchmarked strategy and the global aggregate index (green). The bars show the difference between the two. Until China’s inclusion, both had approximately the same yield. Today, the yield gap has widened towards 200bp!
At an index level, local currency yields and spreads appear to trade at very expensive levels. Actively managed, well-diversified funds can achieve superior yields and spreads. As a result of this far greater diversification, annual carry on actively managed funds is currently around 2% higher than benchmarks.
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