Even Tiny Shocks Will Punish Emerging Markets in Low-Yield World

(Bloomberg) -- The yields on emerging-market bonds are so tight that even the slightest turbulence could impose huge losses on investors.

The influx of cash into the bond market has boosted returns, but also made the debt of developing nations more vulnerable to interest-rate changes. Modified duration of euro-denominated debt across developing nations rose to the highest in 12 years, showing the average bond stands to lose 6 cents on the euro if its yield rises one percentage point, according to a Bloomberg Barclays index.

“All of a sudden an investor has no room for error,” said Warren Hyland, who manages emerging-market debt at Muzinich & Co. in London. “You have the most minuscule move and you lose a year’s performance. As yields fall, what you are opening the world to is an ever greater volatile effect if the central banks suddenly change their minds.”

Investors have been jostling for yield since the Federal Reserve and the European Central Bank turned dovish on concern over global growth. And while investors are almost certain that borrowing costs in the U.S. this month will be lowered for the first time in more than a decade, it’s what happens further down the line that’s fraught with risk for the bond market. The worry is that traders are overestimating policy makers’ willingness to ease policy.

Holding bonds to maturity in fixed-income portfolios or buying gold and other alternative assets can help mitigate the duration risk, according to SG Kleinwort Hambros Bank.

“Government bonds offer poor value in absolute terms,” said Fahad Kamal, chief market strategist at Societe Generale’s private banking unit in the U.K. “Buying expensive bonds is one of the discomforts of a low-yield environment, and yields can rise suddenly again, which would lower their mark-to-market value. We hold a variety of defensive assets.”

Negative-yielding debt worldwide climbed to a record $13.4 trillion earlier this month, according to a Bloomberg Barclays index. Developing-nation debt attracted inflows for a fifth straight week through July 10, according to Bank of America Merrill Lynch, which cited EPFR Global data.

The yield on euro-denominated debt from emerging markets fell to 1.63% this month, its lowest since February 2018.

“Buyers probably think these bonds are lower risk due to lower volatility, but not when you buy at such low yields,” said Robert Marshall-Lee, an investment manager at London-based Newton Investment Management Ltd. “Look how much money investors lost in real terms in bonds in the 1970s when inflation increased and that was from a much-higher starting yield.”

--With assistance from Tasos Vossos and Alex Nicholson.

To contact the reporter on this story: Selcuk Gokoluk in London at sgokoluk@bloomberg.net

To contact the editors responsible for this story: Dana El Baltaji at delbaltaji@bloomberg.net, Srinivasan Sivabalan

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