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Inflation-adjusted emerging market bond yields hit record high

The real inflation-adjusted yields of emerging market local currency bonds have risen to their highest level since at least 2004, despite an increasingly desperate “hunt for yield” on the part of global investors.

The gap between real yields in emerging and developed markets also hit its highest level for at least 13 years this year, raising the possibility of strong gains for emerging market local currency bonds if and when the gap returns to more normal levels.

“The differential is at a record high,” said Vladimir Milev, emerging markets strategist at Payden & Rygel, a US-based asset manager. “Local [currency] markets have been a bit of an unloved asset class since 2013, but the attractiveness of this asset class has grown.”

Across emerging markets, average real five-year government bond yields, adjusted for consumer price inflation, are above 1.3 per cent, comfortably above the levels seen at the top of the previous cycles, as the first chart shows. In contrast, real yields in developed markets are negative, as they have been for much of the past six years.

The differential between the EM and DM readings peaked at a record 1.84 percentage points in February. This gap has since dipped to 1.55 points as developed world yields have become a little less negative amid more hawkish signals from central banks, but it still remains well above historic norms.

The anomaly has been driven by rapid falls in inflation in countries such as Russia, Brazil, India and Indonesia which have, so far, not been matched with concomitant cuts in central bank policy rates.

Inflation in Brazil has fallen from double digits to a decade low of 3 per cent since the start of 2016, while the central bank has only cut its Selic rate by four percentage points to 10.25 per cent, leaving a positive real rate of 7.25 per cent.

Russia has seen an even steeper fall in inflation from 17 per cent in 2015 to 4.4 per cent, yet the benchmark one-week repo rate, which also peaked at 17 per cent in 2015, has only been cut to 9 per cent.

Likewise inflation in India is down from 12.2 per cent in November 2013 to 2.2 per cent, but rates have fallen just 175 basis points to 6.25 per cent. Rate cuts in Indonesia have also lagged behind the fall in inflation, while the South African Reserve Bank has raised rates by 200bp since the start of 2014, despite inflation softening over this period.

In all these countries, five-year local currency bond yields are comfortably above inflation, as the second chart shows.

“A number of countries have been able to lower inflation quite aggressively, whereas the central banks have not yet eased policy rates as much as their peers in developed markets,” said Mr Milev.

Viktor Szabo, senior investment manager in the emerging market debt team at Aberdeen Asset Management, said the developments in Brazil and Russia were evidence of orthodox monetary policy, based on inflation targeting, becoming more entrenched in developing countries.

Mr Milev agreed, saying: “Russia has had a pretty phenomenal ability to drive inflation lower in the past two years. The central bank was allowed to maintain the main rate quite a bit higher than would have been expected.

“That’s not fantastic for the economy, but on the flipside they have committed to lowering inflation and by doing so have gained a lot of credibility, which is important for a central bank that was previously not known for its independence.”

Mr Szabo believed geopolitical risk was also deterring Russia from easing policy at a faster pace, while in South Africa “for political reasons, the central bank is not in a position to cut,” given that the country’s anti-corruption watchdog has advised President Jacob Zuma to shift the Reserve Bank’s mandate away from targeting inflation.

“We have a few [emerging markets] that push up both nominal and real yield, not necessarily for macroeconomics reasons, but because of the political risk premium which keeps them at quite an elevated level,” said Mr Szabo, referring to a swirling corruption scandal in Brazil, the political backdrop in Turkey, sanctions against Russia and December’s elective congress of South Africa’s ruling ANC.

Nevertheless, the record high real yields across emerging markets do suggest scope for bond prices to rise if and when these yields normalise.

“We have a preference for local currency bonds,” said Maarten-Jan Bakkum, senior emerging markets strategist at NN Investment Partners, who believed that interest rate cuts “probably will come” and that investors are starting to wake up to the pricing anomaly.

“It’s quite remarkable that in the past few weeks, bond yields in Europe and the US have risen but emerging market local bond yields have not been rising. The real yield is too attractive for people to give up on it,” he said, noting that dollar-denominated EM debt “has suffered a bit more”.

Noting that local currency EM debt has endured “a significant period of underperformance [relative to dollar debt] since 2012,” Mr Milev said “all else being equal there is room for a rally in local markets at this time”.

“If we continue to see inflation going down then surely there is scope for nominal yields to fall,” added Mr Szabo. “The yield differential should be squeezed as developed markets go back to flat or positive real yields and we see some compression in emerging markets.”