How bond markets will change

Trends and scenarios on the bond markets. Analysis by Polina Kurdyavko, Head of BlueBay Emerging Markets, RBC BlueBay

2024 was a similar year to 2023 when it comes to the performance of hard currency debt in emerging markets. Hard currency sovereign bonds have delivered fairly high single digit returns so far on an indexed basis, which is not too dissimilar to the returns the asset class has provided in the previous year. The same goes for corporate debt. Indeed, like last year, we have seen high yield credit outperform investment grade credit in emerging markets. However, this year, the magnitude of outperformance was much more substantial.

This should not be surprising, given that at the beginning of the year we expected a zero default rate for sovereign debt and a below-average default rate for corporate debt. We continue to believe that this view should come true. At the same time, there have been highly differentiated performances within some emerging market segments, particularly in local currency markets. Last year, local currency indices outperformed hard currency indices. This year, local currency indices have posted negative performance, largely driven by emerging market currency weakness.

This was quite predictable, given the lead-up to the US elections and the outcome of the US presidential elections, which put emerging market currencies at a disadvantage against the dollar. However, it would be interesting to see how the asset class will perform in the coming year and where the divergence will occur.

Looking ahead to 2025 and asset class price performance following the US election, the hard currency credit reaction has been rather muted. We are not surprised by this, given that, ultimately, the best prediction of spread performance is the expectation of default prospects.

And we remain quite bullish on defaults in emerging markets. We expect the sovereign credit default rate to remain very close to zero next year and below the historical average of 3.5%. In fact, the expected default rate of emerging market high-yield companies is lower than the expected default rate of US high-yield and European high-yield companies, if we look at sell-side forecasts. This is due to a higher quality and composition of the asset class, which is more skewed towards investment grade credit, as well as a favorable commodity environment, which has allowed emerging market companies to deleverage over the past three or four years.

In local currency, performances could be more nuanced. We expect emerging market currencies to be at a disadvantage against the dollar. Therefore, in our view, from an asset class perspective, the best support for currency positions in emerging markets may be the euro rather than the dollar. That said, we believe performance will be differentiated by region. In particular, in Latin America we believe that emerging market currencies that have suffered a setback so far will get some support from double-digit policy rates in 2024.

In Central and Eastern Europe, however, we believe that central banks are more inclined to continue monetary easing policies and, therefore, forex could be lower.

From a regional perspective, we favor Latin America over Eastern Europe when considering currency positioning in emerging markets. Regarding rates, we believe that being effectively long emerging markets in Central and Eastern Europe could prove advantageous, as central banks have more incentive to ease policies to support growth.

Lastly, the impact of the new president of the United States and his policies on raw materials and geopolitical risk. As for geopolitical risk, it has been high in recent years. And the market is rightly concerned about the implications of some geopolitical conflicts on risky assets. However, we believe that the positive effect of the new US president on reducing selected geopolitical risks, such as Russia and Ukraine, cannot be underestimated. Of course, Israel and Hezbollah/Hamas remain in a much more complicated situation.

There is however a scenario where we could see a de-escalation of geopolitical risk over the next six months. This would have implications for commodity prices, where, in our view, elevated levels could translate into a decoupling between the price of oil, which may indeed normalize, and the price of other rare metals and minerals, which may remain elevated.

This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/come-cambieranno-i-mercati-obbligazionari/ on Sat, 11 Jan 2025 05:00:45 +0000.