* Fed's dovish turn puts floor under EM bonds losses
* Asset class expected to gain up to 4% in Q4
* Investors eye return to positive performance in 2014
By Davide Scigliuzzo
LONDON, Oct 23 (IFR) - This year's losses for emerging market fixed-income investors will be smaller than expected, and many believe the asset class will turn positive in 2014 despite an expected jump in rates.
Emerging market bonds have been among the biggest beneficiaries of the Federal Reserve's decision in mid-September not to start tapering its $85bn monthly bond-buying programme.
Since then, EM sovereigns tracked by JP Morgan's benchmark EMBI Global Index have gained 2.37%, compared to a 1.73% return for US high-yield corporate bonds and a 0.91% gain for 10-year US Treasuries.
Bonds issued by emerging market corporates have performed even better, with JP Morgan's CEMBI index posting gains of nearly 3% over the same period.
The Fed's dovish turn has allowed fund managers to put a floor under losses after the EMBI Global had posted a negative 7.9% return in 2013 up to the central bank's September meeting.
Emerging markets were hard hit in the aftermath of the FOMC's minutes in late May. But returns on EM bonds had been in the red since the turn of the year, as spreads widened after being pushed to extremely tight levels in 2012, when the EMBI Global posted positive total returns of 18.5%.
While recent improvement is far from enough to lift this year's returns for EM debt funds into positive territory, stable market conditions ahead will give investors the opportunity to further tame losses.
"In the absence of negative news, you can get the carry and maybe some increase in price," said Paul DeNoon, director of emerging markets debt at AllianceBernstein in New York.
According to estimates by JP Morgan, the EMBI Global and CEMBI indices could post returns of between 2% and 4% for the rest of this year, assuming that 10-year US Treasuries remain within the 2.50%-2.75% range.
Investors, however, will need to navigate carefully between interest rate risk, which is most apparent in high-quality issuers, and credit risks embedded in higher-beta names, such as high-yield sovereigns or corporates.
"For managers of sovereign-only EM credit, it's been a challenging year. If you wanted to shed all interest-rate risk and keep some yield, you would have been forced into higher-beta credits," said DeNoon.
He said weaker BBB rated or higher BB- rated credits can still offer investors extra value. "In that segment, you don't have as much interest rate sensitivity as in Mexico, and not as much idiosyncratic risk as in Belarus and Ukraine."
Investors are confident that next year the asset class will generate positive returns, even in the face of an expected rise in US Treasury yields.
"Spreads have widened to a more appropriate level this year," said Luca Sibani, head of discretional and total return investments at Epsilon SGR, an asset manager in the Intesa Sanpaolo group.
"Even if we assume a limited additional spread widening in 2014 and a negative performance of US Treasuries, EM bonds can still generate a positive performance next year."
ING Investment Management, for example, estimates returns for the EMBI Global Diversified index of between 2.1% and 3.5% for 2014, assuming spreads remain at current levels of around 310bp and that the yield on 10-year US Treasuries goes no higher than 3.20%.
Sovereign issues are the most attractive credits, according to Sibani. "There has been a sizable correction in that space and net issuance overall has been quite modest compared to that of corporates."
While many continue to see value in emerging market corporates, investors have undoubtedly become more selective.
Appetite for subordinated trades, for example, has not always been strong, while some of the lowest-rated corporates able to tap the market earlier this year would arguably struggle to find buyers in the current environment.
"We are... selectively cautious about being sucked into long-duration and subordinated bond structures," said John Bates, an emerging markets analyst at PineBridge Investments. "We remain focused on credit fundamentals rather than outright pricing." (Reporting by Davide Scigliuzzo; Editing by Sudip Roy and Alex Chambers)