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Gundlach bullish on emerging markets signals debt back in vogue

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(Bloomberg) — Remember when bond investors were fleeing emerging markets, convinced the debt was doomed in an era of less Federal Reserve stimulus?

That was so 2013. This year the notes may be among the best bets, particularly those with longer maturities and denominated in dollars. Here’s why: Emerging-market bonds are paying an average of 1.5 percentage points more than similarly rated U.S. corporate debt. And there’s growing demand for it right now as confidence builds that this cycle of repressed borrowing costs isn’t ending any time soon.

Jeffrey Gundlach, chief executive of the $50 billion investment firm DoubleLine Capital LP, said he’s “quite bullish” on such debt. “The flows underlying longer-dated emerging-market debt are incredibly strong,” he said yesterday in an interview with Matthew Winkler, editor-in-chief of Bloomberg News, at Bloomberg LP’s New York headquarters.

Some of the demand is coming from investors like the Illinois Municipal Retirement Fund, which opted to shift $200 million from high-yield bonds to a money manager focused on emerging-market debt, according to March 28 meeting minutes.

In June 2013, dollar-denominated, emerging-market bonds plunged 4.1 percent, a bigger decline than for either U.S. high- yield or investment-grade notes, according to Bank of America Merrill Lynch index data. That was largely a knee-jerk response to the Fed’s plan to taper monthly bond purchases, slowing a program that’s fueled demand for riskier assets.

Extra Yield

The Fed has slowed the pace of its debt buying, yet the worst-case scenario of soaring yields has failed to materialize. The opposite has happened, with 10-year Treasury yields falling to 2.58 percent from 2.84 percent on Dec. 17, the day before the U.S. central bank announced its taper.

While emerging-market notes have gained 4.3 percent this year, they still haven’t caught up with U.S. corporate debt with similar BBB ratings, which has returned 5.4 percent, Bank of America Merrill Lynch index data show.

And bonds of developing nations still yield 1.5 percentage points more than their comparably rated U.S. company counterparts. That’s an extra 0.5 percentage point above what investors have demanded on average to own the debt during the last five years.

Reserves Stockpile

That extra yield is luring investors, with cash pouring into emerging-market bond funds for the five weeks through April 30, the longest stretch of inflows in a year, according to Bank of America Corp. and EPFR Global data. That follows about $16 billion of withdrawals from such funds in the first three months of the year in the face of slowing economic growth.

It’s not only yield. While the growth of emerging economies is slowing, they’re still expected to expand more quickly than developed nations in the next few years.

To boot, developing countries are stockpiling more foreign- currency reserves than ever before. A dozen of the largest such nations boosted such holdings to about $3 trillion from $2 trillion five years ago. Those assets typically give investors more confidence that the countries have the financial resources needed to fight a crisis.

Russian Debt

Some emerging-market bets are paying off big time. Turkish bonds have gained 7.8 percent this year as that nation’s central bank raised borrowing costs. And Venezuelan bonds have returned 11.9 percent. Ukrainian debt, on the other hand, is down 8.9 percent.

As for Russia, which is mired in an escalating conflict with Ukraine, Gundlach predicts holders of the region’s bonds will get their money back. “Russian debt is fine,” he said.

Bottom line: Investors are still hunting for bigger returns, and they have more cash than they know what to do with. For now, this bodes well for developing countries and those who put their money with them.