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ETF Specialist

Hidden Risks in Emerging-Markets Debt?

Fickle foreign portfolio flows add another dimension of volatility.

Emerging-markets bonds, along with other higher-yielding fixed-income assets such as junk bonds and bank loans, have seen a surge in flows in recent years. Investor interest has been driven in large part by persistently low yields across the developed world. Growing demand for emerging-markets bonds also reflects a confluence of other fundamental factors. Emerging sovereigns' fundamentals have been improving, global financial markets are becoming increasingly integrated, and local-currency debt markets in many emerging nations are deepening and maturing. According to Morningstar Asset Flows data, the U.S. emerging-markets bond category had average annual inflows of slightly less than $1 billion from 2000 to 2008. This figure spiked to $28 billion in 2012. Emerging-markets debt is also increasingly finding its way into nonspecialist bond-fund managers' portfolios, as represented by its growth as a percentage of assets in fixed-income fund categories such as world-bond funds and nontraditional bond funds.

Are emerging-debt markets able to accommodate these crowds? The International Monetary Fund's semiannual Global Financial Stability Report highlighted a number of trends on the topic. While the growing presence of foreign investors has contributed to the development and expansion of emerging-debt markets, this has also resulted in the asset class' greater sensitivity to changes in global risk appetite. In particular, retail investors, as well as non-emerging-markets specialists, are more susceptible to herding behavior, which can further amplify volatility during periods of sudden market shocks. Another key issue is the increasingly restrictive regulatory environment across the world, which has served to reduce liquidity and dealer inventory in global bond markets. Global banks are less active in making markets in bonds, and hedge funds are trading less. This decline in market liquidity in emerging-markets bonds might serve to exacerbate volatility during periods of stress. While the conclusions of this IMF paper focused primarily on policy recommendations, the takeaway for investors is that global portfolio fund flows are likely to add a unique dynamic and risk (in addition to credit, duration, inflation, and currency risk) to emerging-markets debt.