Widening credit spreads accounted for -4.0% of the EMBI’s negative return; rising Treasury yields, for the other -6.2% with a small positive contribution from interest returns. It's rare for credit spreads and Treasury yields to detract from returns simultaneously; typically, they move in opposite directions, cushioning investor returns (Figure 1). In the past decade, there were only two other periods of concurrent spread widening and Treasury yield rising: during the “Taper Tantrum” of 2013 and in 2018. In both cases, a surprising change in financing conditions loomed large.
Figure 1: Treasury Yields and EM Bond Spreads Rarely Rise Together
Emerging Market Bond Index Returns | Hard Currency
In 2013, the Federal Reserve’s surprising decision to taper asset purchases provoked the market “tantrum.” In 2018, the Fed’s surprising decision to hike the Fed Funds rate from 1.50% to 2.50% caused a sell-off; the market had not responded strongly to rate hikes from 0% to 1.50%.
Similarly, in Q1 2022 the Fed said it would raise rates faster and sooner than the markets had expected. In this case, the Fed was responding to a one-two punch: a broad-based inflation surge (due to pent-up demand and supply-side disruptions) and a commodity price shock related to Russia’s invasion of Ukraine. The unexpected tightening of global financial conditions shocked the markets, negating the typically negative correlation between Treasury yields and credit spreads.
This Too Will Pass
But surprises tend to dissipate, and expectations do adjust. Sharp declines in emerging-market debt indices have typically been short-lived, and often the rebound has been rapid. After the sharp selloffs in 2013 and 2018, investors were rewarded for staying in the asset class or using market weakness as an entry point (Figure 2). There have also been periods in the last decade when both Treasury yields and credit spreads have declined, delivering exceptionally strong returns—most recently, in 2019 and early 2020. The pandemic rudely interrupted that “Goldilocks period” for Emerging Market Debt investors.
We believe that financial markets are likely to soon deliver the diversified sources of return that are key to asset allocation. While historical returns do not necessarily predict future returns, we maintain that credit spreads and Treasury yields are likely to return to moving in opposite directions, cushioning returns. Research and active management will be crucial to garnering the full potential benefit of a rebound, in our view. Once the initial shock wears off, markets should start to differentiate again among countries, companies and individual bonds, and returns will likely diverge sharply. We maintain that investors would benefit from research to identify the likely winners and losers.
Figure 2: EMD Index Has Historically Bounced Back Quickly After Prior Drops
Total Return Index Level, All Series Rebased to 100 on January 1, 2008
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COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
The following indices may be referred to in this document:
Bloomberg US Government 10 Year total return Index ─ The Bloomberg US Government 10-Year Total Return Index is a wealth series that starts on January 1, 1999, based on holding US 10yr treasuries (see last chart – showing the complete wealth series to date); calculated in USD; unhedged and rebalanced monthly.
ICE BofA US Corporate index ─ ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.
ICE BofA US High Yield Index ─ ICE BofA Merrill Lynch US High Yield Index (H0A0) tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
J.P. Morgan EMBI Global Diversified Index ─ The J.P. Morgan ESG EMBI Global Diversified Index (JESG EMBIG) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.