Emerging-markets debt: A new world in fixed income
In This Article
- Emerging-markets debt is a multi-faceted asset class that tends to be under-represented in U.S. investors portfolios.
- After several years of struggles, emerging economies are back on the rise and expected to outgrow their developed-markets counterparts.
- Emerging-markets debt is issued in dozens of currencies by both sovereign governments and corporations, giving it a built-in diversification benefit.
An introduction to emerging-markets debt
Despite being an investable asset class since the late-1990s, emerging-markets debt (EMD) remains poorly understood—and, by extension, under-owned—by U.S. investors. To the degree they’re familiar with EMD, investors may recall periods of volatility: the Russian default, the Asian financial crisis, or even the Great Recession (which negatively affected emerging market returns). In its relatively short history, EMD has experienced high highs and low lows. But similar to the S&P 500 Index, which contains a mix of companies, EMD encompasses a large and diverse array of securities across sectors. This rapidly maturing asset class is now valued at more than $20 trillion, including bonds issued in dozens of currencies by both governments and corporations (Figure 1)1
Underpinning this expansion has been an evolution within emerging-markets (EM) economies. Reforms and financial liberalization have helped strengthen EM balance sheets, lower inflation, as well as deepen and broaden the pool of creditors. At a time when domestic fixed-income markets are providing historically low rates of return, many portfolios remain under-allocated to this diverse and dynamic asset class.
Emerging-markets are back on the rise
The developing world is driving global growth—with more favorable demographics, improving governance, and rapid financial development. According to the International Monetary Fund(IMF), developed-market (DM) GDP is expected to increase by only 2.0% in 2017, while EMGDP should expand by a more robust 4.6%.2 This growth premium, which bottomed at 2.2%in 2015, should average 3.1% over the next five years. EM countries accounted for nearly 70% of the rise in global GDP from 2010-2015, a ratio they are expected to maintain for the foreseeable future (Figure 2).3 Eighty-five percent of the world’s population and 90% of people under the age of 30 live in EM countries, supporting higher levels of growth well beyond the end of this decade.4
EM countries are also benefiting from a general improvement in governance over the past few decades. Many developing nations have liberalized their capital markets through privatization of state-run enterprises, the alleviation of restrictions on foreign investors,and the development of retirement markets and pension funds. Partially as a result, EM corporate issuance now surpasses new EM sovereign debt. Monetary and fiscal authorities have used previous crises to establish independent central banks and more market-based currency regimes,while also tightening their balance sheets. The debt-to-GDP ratio (including government,financial, and corporate securities) is far lower in emerging markets (69%) than in developed markets (172%).5
Economic modernization has come hand-in-hand with financial development, producing more sustainable markets by broadening EM’s institutional investor base and expanding the size and breadth of financial products available. This has attracted foreign investors not just from the U.S. but also from other EM countries. As a result, EM economies are now less dependent on DM but increasingly interconnected with one another.
Growing investor interest in EM is reflected in broader coverage of these markets in international benchmark indices. Back in 1999, the JP Morgan Emerging-markets Bond Index - Global (EMBI Global) included 27 countries.6 Today, it contains 66.7 Still, the EM fixed-income universe remains underrepresented: EM accounts for 60% of global GDP but makes up just 11% of global bond markets.8 Furthermore, less than 10% of all EM fixed income is represented in the JPMorgan,sovereign, corporate, and local currency benchmarks. While China’s largely uninvestable market accounts for close to 50% of outstanding EMD, most indexes do not come close to encompassing the available universe of securities.
What are the risks?
The risks of EMD investing fall into two main categories: broad macroeconomic risk, which is largely external, and idiosyncratic risks affecting single countries or regions. The first type of risk was most apparent in 2008, when a financial crisis tipped most large economies into recession. Although the crisis originated in developed markets, EM currencies and stock prices fell while credit spreads rose, as investors withdrew money from risky assets.
Emerging markets experienced a different external shock beginning in 2013, when a sudden rise in U.S. interest rates—known as the "taper tantrum"—caused EM currencies to plummet. Their struggles magnified when oil prices began a 20-month, 75% decline in 2014, putting commodity-oriented countries and companies under pressure amid rising credit spreads. The sharp rise in the U.S. dollar during this period also negatively affected local-currency bond returns. Today, a repeat of either of these scenarios seems unlikely given the stronger global economic outlook and improving EM credit dynamics (Figure 3).
Another external risk that has cropped up recently has been the move toward trade protectionism in some DM. Speculation that the U.S. might adopt more restrictive trade policies led to a sharp but brief selloff in EM currencies following the November 2016 U.S. election. Most, however, have recovered from those losses and then some, as specific protectionist policies have been slow to take shape.
While external risks have claimed their share of headlines, EMD risks associated with individual countries have also been a focus for investors. With 66 countries included in the EMBI Global benchmark, there’s been no shortage of idiosyncratic risk (e.g., Venezuela, Brazil, South Africa, and Turkey). Fortunately, as EM economies have become increasingly flexible, severe crises have been less frequent — and the potential for single-country risk to affect the entire EMD landscape has fallen. Even so, avoiding possible flashpoints remains a core function of an EMD portfolio manager. Research and risk mitigation are crucial benefits of active management.
China’s growing debt
As the largest EM economy and issuer of debt, China and its risks deserve special mention. China’s rising debt level — increasing twice as quickly as its economy — has grown from 150% of GDP in 2008 to over 250% today and will likely increase further in the next few years according to the IMF (Figure 4).9 The "good news" for EMD investors is that most of this debt is owed by either state-owned-enterprises or companies in state-sponsored sectors such as construction and property, or is tied to local government and infrastructure spending. All of these segments are considered critical and in a crisis likely to be ably backed by the central government. While China allowed a struggling company to default for the first time in 2015 and was recently downgraded, to A1, by Moody’s Investor Services for the first time since 1989, its overall corporate default rate remains low at 0.1% (versus 2% in the U.S.).10
Though unlikely, in our view, a financial crisis originating out of China today could spark one of two contagion scenarios: directly, via counter-party risk from Chinese companies, or indirectly, by tainting sentiment across EM. We believe China could easily manage a solution with affected counter-parties in the event of a domestic banking crisis, given its sufficient assets to cover debt. Indirectly, however, market fear over an internal Chinese event could spread, potentially leading to a pull back in foreign investment affecting other EM countries. This in turn could threaten EM currencies and bond prices. Active management that diversifies across regions, issuers, and currencies mitigates the risk of contagion.
Where does EMD fit in a portfolio?
Despite EMD’s underrepresentation—or perhaps because of it—there’s a strong case for U.S. investors to include the asset class in their portfolios.
Although EMD securities may be denominated in hard currencies (e.g., the U.S. dollar, euro, and yen), most outstanding EM debt is in local currencies, as shown earlier in Figure 1. Local-currency bond returns hinge on both the price of the underlying bond and the value of its currency of denomination versus the U.S. dollar. While currency risk typically causes local debt to trade with higher volatility than its dollar-denominated counterpart, the benefit to investors is apparent in the higher yields available, particularly as one looks to less developed frontier markets (See Figure 5).
Diversity across a range of security types and characteristics is one of EMD’s defining features. For example, returns on local and hard-currency debt do not always move in tandem, providing a built-in low-correlation benefit that can improve the asset class’ risk-adjusted return. Dollar-denominated EMD, for example, trades based on the issuer’s creditworthiness, but is also sensitive to changes in U.S. interest rates, whereas prices of local bonds move according to changes in local rates and currencies. Figure 6 shows historical summary statistics for several major EMD indices. Combining these three indices in an equal-weighted blend has provided efficient risk-adjusted returns that are uncorrelated with U.S. interest rates — a desirable and currently elusive characteristic in fixed-income markets.
Quality and compensation for risk
EM sovereign- and corporate-debt issuers generally carry lower credit ratings than their counterparts in the U.S. As a result, when a country such as Indonesia issues debt in U.S. dollars, it offers a higher yield than similar-maturity U.S. Treasuries. Nonetheless,the majority (58%) of the securities in the Bloomberg-Barclays EM Aggregate are rated BBB- or better, which qualifies as investment grade.
Even with this higher average credit rating, EMD yields compare favorably to U.S. high-yield bonds, all of which are rated BB+ or below, by definition. EM corporates, in particular, tend to provide higher yields than lower-rated U.S.firms. This often makes them attractive holdings for U.S. investors.
We would not recommend swapping out a high quality U.S. bond portfolio for one consisting entirely of EMD. But our recent research,summarized in the white paper, "Fixed Income Strategies for Low and Rising Rates," indicates that devoting one-quarter of a bond allocation to EMD has historically led to higher returns over time. In periods of rising interest rates, an allocation to EMD had a particularly positive effect on risk-adjusted returns.
Tracking EMD benchmarks is tricky, consider active management
EMD is a challenging asset class in which to invest using a passive strategy. Even the broadest indices fail to capture a significant portion of the $20+ trillion in outstanding EM debt. The diversity of issuers and the limited liquidity in certain parts of the asset class has led to significant tracking error between passive EMD portfolios and their benchmarks. For example, the largest EMD exchange-traded fund (ETF) lagged its benchmark by more than 1% per year from 2012-2016.11 In contrast, during that time, major ETFs tracking other benchmarks such as the Bloomberg Barclays U.S. Aggregate Bond Index delivered annual performance within a few basis points of their more-liquid benchmarks.
Experienced managers can improve upon passive investing by taking advantage of the broad and diverse EMD universe. They can employ greater selectivity within the benchmark through diligent credit research and well-considered macroeconomic views. Beyond that, active managers can access frontier local markets, and EM corporate specialists can invest in higher yielding opportunities when they are compelling. Active managers can also adopt risk controls such as hedging currency or credit risk that indexes, by definition, do not employ.
The opportunity in EMD today
The same characteristics that make EMD an attractive addition to a portfolio have helped it outpace every other segment of the global fixed-income market by a wide margin in 2017. The widening gap between EM and DM economic growth, appreciating EM currencies, and liberalizing financial markets are beneficial in both the short and long term. Therefore, we believe now is still a good time to add judiciously to the asset class, keeping in mind the importance of active management in light of the recent rally.
After an unsteady recovery in the wake of the global financial crisis of 2008, EM economic growth has finally resumed, and corporations in the developing world are boosting earnings at their fastest pace since the initial recovery in 2009. Perhaps more importantly, EM companies’ balance sheets are improving, reflected in the dramatic slowdown in credit ratings downgrades following a rocky period in the beginning of this decade. Experience tells us that investor flows tend to move into EM assets during these periods of acceleration, supporting asset prices even after they’ve risen considerably.
As recently as two years ago, EM countries faced an unpleasant combination of high inflation from rapidly depreciating currencies and weak domestic growth. Thanks to a variety of factors both internal (lower inflation) and external (a weaker U.S. dollar), circumstances have improved. Central banks from Brazil to Indonesia have now been able to cut interest rates without experiencing capital outflows or rapid currency depreciation. With expectations for further monetary easing in EM, we believe local-currency bonds — whose prices increase as EM interest rates fall — present a particularly compelling opportunity.
We also cannot ignore that with interest rates in DM still near historic lows (Figure 7), the search for yield will continue to support EMD in the near term. As always, selectivity is key. Less-developed frontier markets typically have smaller bond markets, but their economies are collectively expected to grow by more than 5% in both 2017 and 2018.12 For example, we see moderating inflation in the Dominican Republic over the past few years as a sign that the country’s debt may merit greater inclusion in a portfolio.
Wrapping up: a compelling asset class for a low-yield world
As an underrepresented asset class in most global benchmarks, EMD is systematically under-owned by institutional investors. We believe it can enhance a portfolio’s risk-adjusted returns in almost any environment. While DM economies remain mired in a period of low interest rates, a higher allocation to EMD, despite its attendant risks, still makes sense, in our view.
At the moment, with EM balance sheets stronger than they’ve been in years and growth on the rise, EMD looks especially attractive. Investors should ideally obtain exposure to the full breadth and depth of the asset class, embracing the diversity that has led to superior returns over time. Based on both EMD’s strong long-term track record and the availability of experienced managers to potentially add value relative to the prevailing EMD benchmarks, we believe an active investment approach is best suited to this asset class.
2 "World Economic Outlook, Update," International Monetary Fund, July 24, 2017, p.7.
3 GDP at constant prices, International Monetary Fund, World Economic Outlook database, April 2017.
4 Barnes, P. "Why Emerging Markets Have Better Demographics," http://marketrealist.com/2016/12/emerging-markets-better-demographics/, Market Realist, December 2016.
5 International Monetary Fund, World Economic Outlook database, as of April 2017.
6 "Methodology brief: Introducing the J.P. Morgan Emerging Markets Bond Index Global (EMBI Global)," JP Morgan, August 3, 1999, p. 1.
7 FactSet, as of 9/11/2017.
8 Dehn, Jan, "The Emerging View, The EM fixed income universe version 6.0," Ashmore, August 2017, p.1.
9 International Monetary Fund, World Economic Outlook database, April 2017.
10 Hamlin, K., "Can Xi Jinping Defuse China’s Debt Bomb?," Bloomberg, August 1, 2017.
11 Standard & Poor’s SPIVA Scorecard, Full-year 2016.
12 "World Economic Outlook, Update," International Monetary Fund, April 2017.
Risks and other important considerations
This material is presented for informational purposes only and may change in response to changing economic and market conditions. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results.
Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments.
Diversification does not assure a profit or guarantee against loss.
Fixed-income investments are subject to market, interest-rate, and credit risks. The risks associated with foreign investments are often magnified in emerging markets where there is greater potential for political, currency, and economic volatility. Securities issued in emerging market nations may be less liquid than those issued in more developed countries.