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Investors often look to emerging markets for higher returns during periods of growth, but they can suffer sharp losses during downturns.
Investors often look to emerging markets for higher returns during periods of growth, but they can suffer sharp losses during downturns.

Bond investors regain appetite for emerging markets

Inflows into emerging-market bond mutual funds hits 10 consecutive weeks, the longest stretch since 2017

The collapse of bond yields in Europe and the U.S. is driving investors back into battered emerging markets, fueling gains despite a series of high-profile defaults and concerns about the pandemic’s blow to fragile economies.

Individuals and institutions have put money into emerging-market bond funds for 10 weeks in a row starting in early July, the longest such stretch since late 2017, according to EPFR Global data. The bulk of the money came in three weeks spanning late August and early September, when net inflows hit about $8 billion.

Emerging-market bonds rated below investment-grade currently pay a yield of about 7.6%, down from about 11.5% in March but still 1 percentage point above their level before the pandemic, according to a widely followed JPMorgan Chase & Co. bond index. In contrast, yields of below investment-grade corporate bonds in the U.S. have already returned to pre-coronavirus levels of about 5.5%, according to Bloomberg Barclays index data. Yields fall as bond prices rise.

Source: EPFR
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Source: EPFR

“Emerging markets continue to look attractive and cheap versus developed markets," said Yacov Arnopolin, an emerging-markets debt portfolio manager for Pacific Investment Management Co. “We are back to yield starvation, the same yield starvation we experienced before Covid."

Investors often look to emerging markets for higher returns during periods of growth, but they can suffer sharp losses during downturns. Emerging-market funds fell out of favor even before the coronavirus struck because of falling commodity prices and high-profile defaults by Argentina and Ecuador. The pandemic turned withdrawals into an exodus, but now investors are dipping back in because there are few bonds left in the U.S. and Europe that still pay attractive yields, analysts and portfolio managers say.

Individuals and institutions pulled about $53 billion from emerging-market bond mutual funds and exchange-traded funds from March to the end of June, worried that the coronavirus would hit more fragile economies hard, causing a wave of defaults.

Debt restructurings have been limited so far, but investors were slow to return, in part because they were buying other types of debt in developed markets. U.S. high-yield bond funds, for example, took in about $33 billion from March to June.

Sustained inflows into emerging-market debt funds started in July and have slowly grown to about $15 billion since then. The buying has lifted bond prices, pushing down yields, but emerging-market bonds have yet to catch up to the rally in developed markets, which benefited most from central-bank intervention.

Some warn the rally could prove short-lived, citing risk factors ranging from trade tensions to the U.S. presidential election. And most investors are still shying away from debt issued in local currencies, many of which have been hammered by volatility in foreign exchange markets. But overall emerging-market bond yields could decline another 0.30 percentage point by the end of the year as investors continue to buy, said Eric Ollom, a strategist at Citigroup.

Bonds issued by countries and companies with investment-grade credit ratings in the developing world have already retraced much of their losses but high-yield borrowers still offer good value, he said. Mexican oil producer Petróleos Mexicanos’s 6.84% bond due in 2030, for example, yielded about 7.5% this week compared with around 5.5% in mid-February, according to data from MarketAxess.

“When you have a crisis, investors say ‘enough emerging-markets spice, I want home cooking,’" Mr. Ollom said. “Now that home cooking is tasting boring and they are saying, ‘I want more emerging-markets spice.’"

Write to Matt Wirz at matthieu.wirz@wsj.com

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