Emerging markets (EM) bonds offer benefits that are hard to find in today’s investment landscape – an attractive risk/return profile, higher yields, robust economic fundamentals and more. The asset class warrants a closer look.
- EM countries show increasingly robust fundamentals – they are also responsible for a growing share of global GDP, plus better fiscal management has led to the EM debt-to-GDP ratio falling well below that of developed markets
- The EM external debt market has grown and evolved over the past decades
- EM debt offers appealing yield levels within a credit portfolio
- The credit quality of EM debt has improved over the past 25 years
- EM debt acts as a good diversifier, with EM bond funds enabling investors to express the true market weight of this asset class
A more convincing story
Investors’ appetite for EM debt (EMD) has been growing almost as quickly as the economic revolution these nations have experienced.
From less than one-third of global GDP in 1980, EM are now expected to drive around 40% of this figure worldwide. The current trajectory suggests this trend will continue, as does the increasing resilience of emerging economies to macro and geopolitical headwinds.
Lessons learned from the financial crises of the 1980s and 1990s in Mexico, Asia and Russia, have made EM nations more disciplined and fiscally prudent than ever before. Fuelling broadly stronger fundamentals are a combination of:
- Low government debt to GDP ratios (compared with developed markets)
- Better macro management via the closer monitoring of inflation
- Rising foreign reserves
- Healthier corporate debt levels
- More credible EM central banks
All this has resulted in rating upgrades and stronger credit markets, in turn attracting larger capital inflows.
Amid the more wary outlook for many developed markets over the next year or so, at least, the importance of exposure to EM cannot be underestimated.
Making more sense all the time
In the fixed income space, in particular, this view is supported by the various tangible benefits of investing in EM that have sprung from the growth and evolution of this asset class.
This holds true across the EMD universe – whether sovereign hard-currency or local-currency debt, or EM corporate bonds.
Tremendous growth of the EM debt market
A snapshot of the Bloomberg Barclays Emerging Markets USD Aggregate Bond Index in 1980, and then again in 2018, is testament to this: an increase in both the size of the EM debt market and the number of countries from where bonds have been issued, alongside with a reduction in the percentage of high yield names.
Source: Vanguard based on Bloomberg Barclays Emerging Markets USD Aggregate Bond Index data as of 31 December 2018.
Further, in nearly two decades, the value of EMD outstanding has increased from less than US$244 billion, dominated by just under 400 bond issues, to more than US$3 trillion from over 2,300 issues in more than 90 countries across Latin America, Eastern Europe, Africa, the Middle East and Asia.
Improved credit quality: 55% in investment grade
Beyond such headline figures, other improvements have been seen over time. Since 1993, for example, the weighted average credit quality of EMD has moved up to just one notch below investment grade as emerging economies become more diversified and adopt supportive policies such as flexible exchange rate regimes.
This is contrary to popular belief that the asset class is predominantly sub-investment grade; in fact, approximately 55% of the JP Morgan Emerging Market Bond Global Index is rated BBB and above.
Attractive risk-adjusted return
The risk/return profile of EMD also deserves a more thorough look. While this asset class inevitably comes with higher risk than traditional or developed markets fixed income instruments, investors tend to be well compensated, particularly relative to EM equities and other risky asset classes.
Historical risk-adjusted returns show that EM has led the way
Note: Investment involves risk. Past performance is not a reliable indicator of future results.
Source: Bloomberg, JP Morgan as at 30 September 2019. Indices used as follows: S&P 500 = S&P 500 Index; Global Equity = MSCI ACWI; EM equity = MSCI Emerging Market Index; US Aggregate Bond = Bloomberg Barclays US Aggregate Bond Index; Global Aggregate Bond = Bloomberg Barclays Global Aggregate Bond Index; Global Credit = Bloomberg Barclays Global Credit Aggregate Bond Index; US HY Credit = Bloomberg Barclays US High Yield Index, Europe HY Credit = Bloomberg Barclays Pan-European High Yield Index (USD hedged); EM Hard Currency Bond = J.P. Morgan EMBI Global Diversified.
A yield generator in your credit portfolio
Yet perhaps the greatest appeal for many investors lies in the role of EMD as an attractive yield generator within investment portfolios.
Given the current low – even negative – yields in some developed markets, the 4.95% yield for EM bonds denominated in U.S. dollars as of 31 October 2019, looks ever-more attractive.
Sources: Bloomberg Barclays Emerging Market USD Aggregate Bond Index, Bloomberg Barclays Multiverse Index as at 31 October 2019. Yields for the United States, Canada, Germany, UK, Italy and Japan are the 10 year maturity bonds mid yields. Source: Bloomberg as of 31 October 2019.
Weighing the risks
The nature of EM, however, makes it imperative for investors to carefully consider some of the potential external risks involved with exposure to EMD in portfolios.
These span market volatility, geopolitical uncertainty and currency fluctuations – all of which are risks that go hand-in-hand with the dynamic, fast-paced nature of the economies within the EM universe.
These characteristics can make these nations a little more prone to (unfavorable) regulatory or other reforms, with the potential to disrupt domestic financial markets or dent investor confidence.
A solid portfolio building block
Despite the possible downside, EMD generally enables investors to achieve the key benefits of return and yield enhancement, strong diversification potential and the ability to express a tactical view of EM.
These are of particular relevance to those investors with an extended time horizon, given there is often a need to hold EMD bond funds for longer time period to counter volatility. EMD even provides an option to be a substitute part of an equity allocation; over the past 20 years, for example, returns have been equity-like while exhibiting a fraction of the downside.
More broadly, with the notable growth in EM a more recent phenomenon, EM hard-currency debt is still underrepresented in conventional fixed income benchmarks. Adding EMD to your portfolios can help you express true market-value weight of the asset class.
Going forward, and in line with the EM growth story, it will be interesting to watch the extent to which EMD lives up to its potential – and attention – as a strategic or tactical portfolio building block.
Originally Posted on December 4, 2019 – A Compelling Case for Emerging Markets Debt
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