Emerging market debt (EMD), with all its asset-class tentacles, is well entrenched in the modern asset allocator toolkit. This is perhaps unsurprising. The EMD Sharpe Ratio (a key measure of risk-adjusted returns) over the past 20 or so years is comparable to the S&P 500 equity index, and superior to emerging market equities.1 While EMD might not give the same annualized returns as equities, it still represents a compelling proposition relative to the amount of risk taken.
Over the last 40 years, we've have seen a large-scale increase in bond issuance across EMD. Investors now have access to an unprecedented range of opportunities across over 80 countries. This includes bonds in both US dollars and local currencies, from government and corporate issuers, and across a wide range of issuer credit quality. Whether as part of a core or satellite allocation, the diversity of the asset class, along with attractive long-term risk-adjusted returns, are key reasons why EMD allocations now exist in most portfolios, however large or small.
Some key well-known trends in EMD
We believe a couple of key trends will continue to shape investment opportunities in EMD over the medium to long term. Firstly, the emerging markets' (EM) growth differential over developed market (DM) bonds, will remain a key positive. Indeed, in the short run, this is likely to widen further in favor of EM, with the International Monetary Fund predicting growth of 3.8% for EM, versus 1.3% for DMs in 2023.2
Secondly, the outlook for the US dollar is always important for EM capital flows and returns. For many years, strong capital inflows into the US have supported the dollar. This was driven, by the exceptionally good performance of US financial assets, especially US equities. In more recent times, much higher US interest rates have bolstered the US dollar. However, US exceptionalism may be ending, and in the event of a US recession, lower inflation would result in lower US interest rates. Lower or even flat US interest rates could spell the end of the long rise in US dollar and allow other currencies to recover.
Thirdly, the focus on environmental, social and governance (ESG) risks will continue to increase. For sovereigns, reforms that improve transparency and strengthen central bank independence will help attract long-term capital. For corporates, ESG incorporation is a powerful tool when it comes to evaluating creditworthiness. An understanding of ESG risks, and engaging in these areas with relevant stakeholders, is increasingly recognized as a requirement for successful investing in both areas.
Are increased risk-free rates problematic for EMD?
Another longstanding attractive feature of EMD is the relatively high yields compared to other fixed-income assets. This was particularly so in the (past) world of generally low yields, including very low risk-free rates of return.
However, risk-free returns that are proxied by cash or short-term US or European government bond yields have risen to 3–5%. Could this weaken the case for EMD assets? The answer is a firm no. EMD yields have risen by even more (in the case of USD bonds, Treasury yields are a component of yields) and are now at the highest level since 2004, if we exclude the Global Financial Crisis (GFC) period. Beyond higher yields, EMD offers diversification benefits and attractive risk-adjusted returns over the long run.
One other notable benefit of EMD is the combination of higher yields with relatively high duration compared to risk-free assets. In other words, investors can lock into the current elevated EMD yields for longer than the shorter terms of DM bonds and cash rates. Furthermore, if overnight rates fall towards the levels we've been accustomed to over the last decade, higher duration can provide upfront profit.
Some less well-known considerations in EMD
Post GFC, the quest for yield pulled previously niche asset classes such as EMD into the mainstream. This helped broaden and deepen the universe and improve liquidity as well as transparency. However, a downside is an increased correlation with other risk assets. As a result, EMD is now more likely to react in a similar direction to equity markets. This means EMD is less of a directional diversifier than before.
With most investors now having some EMD exposure, the potential competitive advantages of owning EMD have also lessened. The industry itself is far more competitive. Managers have evolved more risky strategies in the search for alpha. In the process, however, they may just be getting higher beta with less diversification. Relatedly, EMD is now often seen as a tactical risk-on asset class within the bond universe. In the more volatile world of the last five years, many EMD fund managers have had their fingers burnt as a result of higher downside capture than general indices and benchmarks.
It's not all doom and gloom. The increasing importance of EMD in terms of both index weightings and income availability presents selectors with the scope to deploy more sophisticated approaches to EMD, instead of the ubiquitous risk-on thinking that has dominated the narrative in recent years. For example, for many larger investors, the absence of more conservative product options that can offer more controlled downside risk has motivated some to look more closely at passive EMD options.
The broader problem, however, is a scarcity of more differentiated strategy options within EMD. Proven ability to manage risk within emerging markets is rare, and EMD's usual risk profile can be a barrier to inclusion in core portfolios. As we continue navigating through uncertain times, opportunities could therefore exist for managers that can reliably provide more bespoke downside protection in EMD.
- JP Morgan, EM Bond Index Monitor, April 2023
- IMF World Economic Outlook, April 2023