Less than two years ago, Emerging Market (EM) bonds, as a group, have enjoyed significant returns in what might have been an all-inclusive party. These assets gained traction among international investors as the lower grade debt securities offered higher yields in a low interest rate environment and provided some diversification benefits. Accordingly, there were significant inflows into EM debt, and bond prices rallied as a result.

Since late 2013, however, and more so in the past few weeks, the music has seemingly stopped, and there has been a reversal in the flow of funds. This came on the heels of the US Federal Reserve’s (US Fed) decision to taper Quantitative Easing 3 (QE3), an expansionary policy in which long-term bonds are purchased to help keep long-term interest rates low. Reducing or withdrawing those purchases will decrease liquidity, triggering a rise in long-term rates. In addition, instances of default and deteriorating fiscal conditions in some developing countries proved to be the perfect party pooper. With unsettled EM bond prices and several issuers having to delay decisions to raise funds on the international capital markets, we wonder whether or not the party is over for EM debt.

EM bond returns and fund flows over the years

During the period 2002 – 2012, EM bonds were one of the best performing assets. The average ten-year return for EM US$ denominated bonds was 10.52 per cent, while EM local currency debt returned 12.02 per cent. This exceeded the return on US government and investment grade bonds which was 4.73 per cent and 5.53 per cent respectively. This performance was driven by fairly strong fundamentals, at the time, which included strong growth prospects and improving debt levels.

EM debt was made even more attractive by the extraordinarily accommodative monetary policy stance taken by central banks of developed countries in an effort to lift their economies out of the recession. The US Fed, for example, kept short-term interest rates close to 0 per cent, while pumping liquidity into the market via QE3. This intensified the search for higher returns which investors found in EM bonds. As a result, there were massive fund inflows to EMs. 2012 saw a record US$71.3 billion in net inflows to EM bond funds .

Tables turned

The party has, however, been interrupted by contrasting developments in advanced economies and the EM space. In the developed world, the US economy has grown stronger, prompting the Fed to effect a tapering of its bond purchase programme.

In December, monthly bond purchases were cut by US$10 billion to US$75 billion. Market speculation is that QE will finally come to an end in 2014 and monetary policy will normalise in 2015. This has fuelled fears that the era of ultra-low interest rates is nearing its end. Rising interest rates have the effect of reducing bond prices, with longer tenor bonds being the most sensitive to interest rate movements.

The other party crasher has been deteriorating conditions in EM economies, particularly Latin America and the Caribbean. The IMF recently revised its 2014 growth forecast for the region down to three per cent from 3.1 per cent, and 2015 forecast down to 3.3 per cent from 3.5 per cent.

One of the main hindrances to growth is austerity measures employed to deal with worsening fiscal deficits and rising debt levels. The spotlight was on Barbados, a once model Caribbean territory which has fallen from grace given rising debt and deficits and weakening economic growth. Barbados bonds (with seven or more years to maturity) have fallen by 20 per cent on average from a year ago.

Over in Venezuela, political upheaval, declining oil production and inflation in excess of 50 per cent have contributed to the volatility in bond prices. Further, there have been several instances of default/restructuring including Grenada, Jamaica and Belize.

In light of this, there has been an exodus of fund flows from EM bonds. In 2013, there was a net outflow of US$1.4 billion from EM external debt, and record outflows during the first 6 weeks of 2014 suggest that last year’s figure will be surpassed. As a result, prices, particularly for riskier bonds, continue to underperform.

Recent developments suggest that the EM debt market’s 2:00 am lock-off is fast approaching and the party is winding down. For sure, the days of the “all-inclusive” broad-based rally have ended as investors approach the EM space with more caution. Issuers with weak fundamentals will, therefore, be required to pay a high premium to get on the guest list, even as they seek to fix their fiscal challenges and turn their economies around.

For countries like Jamaica, which might soon seek to tap the international markets to refinance maturing obligations, continued commitment to fiscal discipline is important in order to avoid high debt costs. On the other hand, there may still be a place in the spotlight for issuers in good financial standing, and investors are expected to move to the beat of this subset within the EM bond space.

Simone Hudson-Bernard is a senior research analyst at NCB Capital Markets.