Why investors should consider emerging market debt

Both global equity and debt investors can look to this asset class in their hunt for yield

An investor looks at a stock information board in Shanghai. The overall emerging market capital flows in April were supported by $4.8bn going to China's debt and $13.5bn to Chinese equities portfoliosShow more

Despite Covid-19, the continued pace of economic growth in countries such as China and India has reinforced the role of emerging markets in driving global investment opportunities.

Generally speaking, countries in the EM category have scope to implement fiscal and monetary measures to further support growth. Of course, investors need to be comfortable with headline and idiosyncratic risk, but in a low-yield environment, emerging market debt offers significant potential for those investors willing to take a closer look.

The established bond indices most followed by institutional investors indicate a $6.5 trillion universe of index-eligible securities in hard currency sovereign and corporate bonds as well as in local currency fixed income, making EM debt too big for global investors to ignore.

In fact, against a market and macroeconomic backdrop that has set in motion a global hunt for yield, EMD is a versatile asset – for both global equity and debt investors.

A modest allocation to an equity portfolio, for example, has the potential to mitigate risk with only a modest dilution in returns. For fixed-income investors who are willing to take on some more risk, EMD presents a significant yield pick-up opportunity.

Compelling investment case

EMD provides an attractive yield pick-up relative to developed market bonds. Key aspects of the merits and nature of EMD investment are:

• Diversification benefits: The low correlation and higher growth factor exposures of EMD assets provide diversification benefits for global bond and equity investors.
• Supportive fundamentals: Emerging economies, on average, offer stronger growth potential and lower debt burdens than their advanced counterparts despite the negative effects of the pandemic.
• Higher volatility/drawdown and idiosyncratic risks: Investors need to be aware of these aspects of EMD investing.

In line with the market’s growth, there has also been an improvement in trading liquidity in EM in general. This has helped to lower trading costs.

Over the past five years, for example, the cost of trading in hard currency EMD has decreased significantly – it is now lower than the cost of trading US high-yield bonds. For local currency sovereign EMD, trading costs have remained stable and are lower than that of US investment-grade bonds.

Investors don’t need to commit to one single EMD segment. By blending EMD segments, investors can generate relatively attractive returns, while reducing the risk profile compared with holding a single EMD asset.

Foreign exchange rate movements of EM local currencies against the euro have been a big return and risk driver for local currency EMD.

State Street Global Advisors has observed that the valuation of EM currencies relative to the euro has a significant bearing on investment outcome. Historically, a good time to invest in EMD has been when EM currencies have been undervalued against the euro.

Investing in local currency EM debt during periods when EM currencies are overvalued has typically resulted in poor returns for investors as the subsequent devaluation can wipe out any bond gains.

Today, EM currencies – as a basket – are undervalued relative to the euro. This makes it a relatively good entry point to invest in local currency emerging market debt. However, to benefit from the currency return potential, there would need to be a period of euro weakness/EM currency appreciation. The challenge is in timing the run.

Balancing the risk/reward equation

In general, EMD provides a relatively attractive yield enhancement option relative to investment-grade bonds; while yields are slightly lower than those of high-yield bonds, the average credit ratings are higher.

Yet, regardless of EMD’s positive attributes, investors need to know what they are buying. For instance, within the EMD universe, hard currency sovereign, hard currency corporate and local currency sovereign are the three broad investible segments for global investors.

The hard currency corporate and local currency sovereign EMD assets have investment-grade ratings that, depending on the rating agency, are between three and six notches below global aggregate bonds, while the duration of the indices is shorter.

By contrast, hard currency sovereign EMD has speculative grade ratings on average with a longer duration than global aggregate bonds.

There are also evolving external vulnerabilities to consider across EM. While the past 10 years saw the number of these countries running fiscal and current account deficits shrink and foreign exchange reserves expand, 2020 witnessed a sharp rebound in average government gross debt in EM economies as a percentage of gross domestic product. Further, the International Monetary Fund forecasts this may increase in the medium term.

That said, the level should remain far below that of advanced economies. While average current account deficits as a percentage of GDP are likely to deteriorate in the coming years, they are forecast to be within 1 per cent of GDP.

Embracing EMD exposure

Ultimately, EMD offers investors a relatively attractive growth exposure at a time when advanced economies may struggle to maintain growth. This is reflected in generally superior growth dynamics and significantly lower debt burdens of EM economies relative to their advanced economy counterparts.

At the same time, some EM economies retain significant capacity for policy response by their central banks should it be required in the coming years.

As with most bond investments, income tends to be the dominant driver of returns over the medium to long term. In the short term, however, currency fluctuations can drive return variance in hard and (more so) local currency EMD.

Assessing the fair value of those local currencies can help investors manage that risk – allocating to EMD where the currencies are trading close to, or below, fair value can help build a buffer into the investment decision.

Desmond Lawrence is senior investment strategist, investment strategy and research, EMEA at State Street Global Advisors, which is a member of the Gulf Bond and Sukuk Association