The opportunity in Emerging Market Debt

Emerging Market Debt (EMD) is an asset class consisting of bonds issued by companies and governments of emerging market economies. The investable universe for EMD is approximately $8 trillion, and the asset class is rapidly expanding, having increased in size by 150% since 2012. Additionally, the quality of debt has increased over time, meaning that whilst EMD is riskier than conventional bonds, it no longer carries as much risk it once did.

EMD can be a good diversifier for portfolios. Performance of EMD is determined by different factors to developed market bonds, and exhibits low correlation with developed market bonds and interest rate cycles there. For example, emerging market bonds may be more sensitive to changes in commodity prices, or to the higher degree of political instability in many of these countries.

Understanding the Asset Class

EMD can be issued by the governments (or government owned entities) of emerging market countries, which is known as sovereign debt, or by companies domiciled in emerging market economies, known as corporate debt. This debt can be issued in US dollars, referred to as hard currency debt, or in the currency of the issuing country, which is local currency debt. This means there are 4 types of EMD that can be invested in, summarised in the chart below

Of these four segments, three are generally regarded as investable, as local currency corporate bonds are as not easy to access for western investors.

Hard currency debt is usually issued by less developed emerging market economies. Due to political, social and economic unrest, they may otherwise struggle to attract global investment in debt issued in their own currencies. Hard currency debt therefore often has a lower credit quality than local currency.

Local currency debt is issued by more stable emerging market economies where global investors have reasonable confidence in their financial infrastructure. As one would expect, this means that local currency debt generally has higher credit quality than hard currency. Despite this higher credit quality, local currency is more volatile than hard currency due to the additional currency risk.

Many investors use a ‘blend’ of the three investable EMD segments, which mitigates the risk of holding just one of them whilst still generating attractive returns. The chart below shows the risk vs return of emerging market bonds compared to other bond markets, demonstrating how emerging market debt has the potential to offer higher returns for lower risk. It also highlights the difference between the segments of EMD, and how it is important to understand the differences between them to blend them effectively.

Current Opportunities and Risks

Predictions by JP Morgan, who provide some of the most popular emerging market debt benchmarks, estimate that the asset class will return roughly 7% this year. This is partly due to growth in emerging market economies, where the IMF predicts that emerging economies will outperform developed economies in 2023, with a 3.7% growth rate vs 1.1%. The reopening of China will positively contribute to growth in emerging markets.

Another reason for optimism in the asset class is that many emerging market economies were quicker to react to rising inflation than developed economies and are subsequently further along the rate hiking cycle. Many believe that this is because they have a history of fighting high inflation, and thus emerging market central banks recognise the importance of tackling rising inflation early. This has put them in a better position in the fight against inflation, and points towards a weakening of macro-economic headwinds. However, this also means developing countries will face higher borrowing costs in the short term. Sovereign debt is generally higher duration than corporate debt, so this may provide it with a boost to performance as interest rates begin to fall.

EMD suffered record outflows in 2022, and with the higher central bank rates, yields are now attractive and provide an opportunity to offset the current high inflation we are seeing in the West. In addition, the strength of the US dollar (and weakness of emerging market currencies relative to long term averages), may provide a good entry point for local currency debt. If the US Dollar depreciates (and/or local currencies appreciate), returns will be higher once converted back to sterling or dollars.

References

https://www.imf.org/en/Publications/WEO/Issues/2022/10/11/world-economic-outlook-october-2022

https://am.jpmorgan.com/gb/en/asset-management/adv/insights/portfolio-insights/fixed-income/weekly-bond-bulletin/

Ben Jones - 23/03/2023

Risk Warnings 

Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The funds may have exposure to bonds, the prices of which will be impacted by factors including; changes in interest rates, inflation expectations and perceived credit quality. When interest rates rise, bond values generally fall. This risk is generally greater for longer term bonds and for bonds with higher credit quality. The funds invest in other currencies. Changes in exchange rates will therefore affect the value of your investment. The funds may invest a large part of its assets in other funds for which investment decisions are made independently of the fund. If these investment managers perform poorly, the value of your investment is likely to be adversely affected. Investment in other funds may also lead to duplication of fees and commissions. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or In a timely manner. All or part of the fees and expenses may be charged to the capital of the funds rather than being deducted from income. Future capital growth may be constrained as a result of this.

Regulatory Information 

This material is for distribution to professional clients only and should not be distributed to or relied upon by any other persons. It’s provided for general information purposes only and is not personal advice to anyone to invest in any fund or product. Information taken from trade and other sources is believed to be reliable, although we don’t represent this as accurate or complete and it shouldn’t be relied upon as such. Calls will be recorded for training and monitoring purposes. 
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