June 20, 2014

Mike Conelius Mike Conelius, manager of the T. Rowe Price Emerging Markets Bond Fund.

After significantly underperforming last year, emerging market bonds have rebounded and become a leading fixed income sector this year.

Mike Conelius, manager of the Emerging Markets Bond Fund, says fundamentals and the geopolitical environment are improving in emerging markets and that valuations remain relatively attractive.

"Emerging debt was the one asset class that really underperformed in 2013," Mr. Conelius says. "So entering 2014 emerging debt was about the only asset class that you could say was cheap. Emerging markets were then seen as the cheapest asset class that has gone through some fundamental adjustments and has slowly gotten through some of the political concerns, mostly around elections."

With tensions easing in Ukraine, Mr. Conelius says, "I think we've seen the worst. I think [President Vladimir] Putin will play for a longer term game. And I think the market has recognized the fact that Russia came into this environment very strong comparatively. We've seen almost a full retracement of yields in Russia, and the currency is more stable."

After reducing the Fund's exposure to Russian sovereign debt, Mr. Conelius has recently been investing in selected corporate bonds issued by domestic-oriented companies where the threat of new sanctions is "greatly diminished. We've re-entered the market in a small way because one effect of all this will be lower growth in Russia and maybe more inward orientation of investment that could drive down local interest rates."

At the same time, Mr. Conelius says the market is now more focused on the upside potential of Ukraine, which he says is taking positive steps in terms of governance with help from the west, especially the International Monetary Fund.

"What always stood in the way of Ukraine's potential is the Ukrainian government," he says. "It is the bread basket of eastern Europe. It could be the bread basket of Europe with some of the most fertile fields in the world. It could be an export powerhouse in agriculture. So if you brought in just a degree of western influence in the rule of law and governance, the potential there is enormous."

In addition, he says India's recent election could be a "game changer for re-igniting growth potential. India could be the next Mexico in terms of policies and growth. We could see a whole second wave of companies coming out of India. And Mexico is still a tremendous opportunity on the energy reform front."

While the geopolitical environment is improving, Mr. Conelius says there is still political uncertainty in such places as Turkey, Indonesia, and, importantly, Brazil.

"Brazil is the big wild card," he says. "It's been a bad news is good news environment. As President [Dilma] Rousseff struggles in the polls, the market has been very optimistic that she will lose and we'll have better policies. I think that might be optimistic. But if that were to happen then that would be a tremendous tailwind for emerging debt into 2015."

Emerging market bond yields, about 5% on average, are historically low, but Mr. Conelius says they are attractive relative to other fixed income alternatives and that the markets have overcome many of their challenges.

"Emerging debt has been challenged once more," he says. "We went through the global financial crisis and [Federal Reserve] tapering and election concerns and geopolitical instability. I think the asset class has proven itself to be fairly flexible and policies do adjust and currencies do adjust. It's still where the majority of the [economic] growth comes from, and investors are still underweight this asset class."

Mr. Conelius acknowledges, however, that bond valuations are not as attractive as they were six months ago, so he expects the rest of this year to be a "coupon clipping" year in which investors earn the income but with little prospect of further capital appreciation."

Some of the key risks now include a likely rise in U.S. interest rates and volatility in currency values as "emerging markets are using their currencies as a policy tool and as a source of strength, meaning they are going to use it for flexibility" to adjust to capital flows, Mr. Conelius says.

He remains optimistic on the outlook, noting that more non-traditional investors are participating in the asset class with a longer-term horizon, providing technical and liquidity support.

Investing in bonds involves credit risk and interest rate risk. Investing overseas generally carries more risk than investing strictly in U.S. assets, due to factors such as currency risk, geographic risk and emerging markets risk. Because of the concentration in rapidly developing economies, investing in emerging markets involves a high degree of risk.

The views are as of June 5 and may have changed since that time.
T. Rowe Price Investment Services, Inc. Distributor