As the U.S. continues to teeter on the so-called “fiscal cliff,” emerging market (EM) fixed income investors may be concerned about what this will mean for their bond holdings. Should the U.S. fail to resolve its budget issues, the impact of the impasse will certainly be felt, but may not be as severe as some expect, according to Fran Rodilosso, fixed income portfolio manager at Market Vectors ETFs.
“EM local currency bonds are becoming more strategic, as opposed to purely tactical, allocation for many investors. We believe the market is supported by, in addition to the underlying fundamentals, improved liquidity, expanded yield curves, and a greater opportunity to diversify,” says Rodilosso. “In other words, the money that has flowed in this year might not be as ‘hot’ as in previous years.”
Rodilosso cautions that while the situation has improved, not all the “hot money” has vanished from the market. “We witnessed underperformance on EM local debt in 2011, due in part to outflows on a flight-to-quality trade, so that type of hot money is indeed still there,” he says. “But the progression towards more permanent allocations and, ultimately, lower volatility still appear to be in place.”
Should the U.S. fiscal cliff talks fail, Rodilosso expects that the initial reaction of emerging market local currency bonds will be negative, as investors pull back from “risky” assets. More broadly, a significant drop in U.S. growth would likely dent most EM country fundamentals, as well. At the same time, however, the relative strength of the emerging economies and the relative health of their balance sheets should remain intact as the year draws to a close.“Looking past the current drama with the fiscal cliff, we see the appetite among institutional investors growing for EM local currency bonds in general, with many looking for a diversified basket of securities,” says Rodilosso. “Lately, we are also seeing more interest in the ‘dim sum’ bond market – where investors can gain more yuan exposure, typically through investments in investment grade corporate borrowers from within and without China,” the Market Vectors fixed income portfolio manager added.