Emerging-market debt has become the star of the fixed-income world over the past year as market fundamentals improved and investors diversified away from the U.S. Whether that bull run progresses in the weeks and months ahead will be determined by the war in Iran and resulting energy price spikes.
Since the U.S. and Israel attacked Iran on Feb. 28, government bond yields around the world have risen on worries that a prolonged period of higher oil and gas prices will heat up inflation. Increased inflation could trigger a run up in interest rates, which would in turn boost bond yields. Rising yields mean falling prices for bond investors.
Emerging-markets bond spreads—the distance between their yields and U.S. Treasury yields—have widened by 15 basis points since the war began. That is still a muted response compared to other recent conflicts, indicating investors believe this one will be shorter-lived.
“In the Russia-Ukraine war, the widening was as much as 150 basis points,” said Benito Berber, chief economist for the Americas at Natixis. “I think the market is telling us it is pricing in and discounting only an oil shock, which is temporary.”
Brent crude surpassed $100 a barrel Sunday as Iranian attacks continued to effectively freeze tanker traffic in the Strait of Hormuz.
“While there is significant uncertainty about the duration of the conflict, we expect broader economic effects to be modest,” said Dan Shaykevich, head of emerging markets and sovereign debt at Vanguard.
For investors, a tick up in yields or widening of spreads during the conflict can provide an opportunity to add to their positions. Shaykevich said he has been adding emerging markets exposure with a focus on Turkey, Central Europe, and the Middle East.
Even though Iran is targeting Saudi Arabia and the United Arab Emirates with missile and drone strikes, both countries are still considered quality credits. They have relatively low debt-to-GDP ratios of around 32%. More developed markets tend to have higher debt levels—the U.S., for instance, has a debt-to-GDP ratio of more than 120%.
Spreads on the best-rated Middle Eastern 10-year dollar-denominated sovereigns were as much as 15 basis points wider early last week before moving back down Thursday. Higher oil prices could help stabilize these energy-producing countries’ debt yields.
Less credit-worthy debt in the region hasn’t performed as well. Spreads for Egyptian and Bahraini bonds widened last week by about 25 and 50 basis points, respectively. Shaykevich also sees a “risk of prolonged weakness” in Central European and African local markets.
Asian emerging markets, which import most of their energy from the Middle East, are also vulnerable. But as long as the war isn’t too extended, they should be able to manage, according to Cathy Hepworth, head of PGIM Fixed Income’s emerging markets debt.
“Asian countries are insulated,” Hepworth said. “They have got lots of bumpers. Their currencies can take the pain. Inflation isn’t an issue there. I don’t think there will be much of a growth shock.”
Emerging markets gained traction over the past year as investors looked to diversify away from dollar holdings. The return on dollar-denominated emerging-markets debt was roughly 14%—about double that of traditional U.S. bond indexes. Last year, as the dollar slid more than 9%, emerging-markets bonds returned as much as 20% on a local-currency basis, making them the best performers in fixed income.
But local-currency bonds took a bigger hit than dollar-denominated bonds last week as the dollar attracted investors looking for safety. The Bloomberg Emerging Markets Local Currency Government Index was down 1.6% on Friday from its Feb. 26 close, while the Bloomberg Emerging Markets USD Aggregate Index was down by just 0.76%.
The iShares J.P. Morgan Emerging Markets Local Currency Bond ETF, which tracks the J.P. Morgan local currency index, is up about 10% over the past year but was down nearly 3% last week. That compares to a 5.6% gain over the past year in the iShares J.P. Morgan USD Emerging Markets Bond ETF, which tracks the dollar-denominated emerging-markets debt index. It only lost 1.4% last week.
According to Berber, Natixis’s chief economist, commodity-producing countries with improving market fundamentals, such as Brazil and Mexico, are most likely to weather the war-related volatility well.
“Both economies will grow around 2% with moderating inflation, and, in the case of Brazil, significant policy and rate cuts,” he said. They “will probably outperform the rest of emerging markets once the extent of the conflict is clear.”