Size, diversification and fundamentals: Three reasons to be optimistic about emerging-market debt

It’s time to put the tired old cliches aside: EMD offers investors the opportunities to achieve attractive, sustainable returns from some of the world’s most dynamic economies.

Despite consistently delivering strong risk-adjusted returns, emerging-market debt (EMD) is still viewed as a relatively risky or niche part of the fixed-income universe. Many investors remain structurally underinvested in the asset class, either ignoring it altogether or only allocating to it on a tactical basis. 

Such thinking is outdated; it is time to address the common misconceptions investors have over EMD to understand why. Strategic allocations to the asset class can offer investors:

  • Diversification across geographies and economic cycles
  • Strong and improving fundamentals relative to developed-market (DM) peers
  • The opportunity for attractive risk-adjusted returns

Too big to ignore

Emerging markets represent over 40 per cent of global GDP, yet EMD makes up less than 23 per cent of global fixed-income assets – highlighting it is a structural overweight for many investors.1 Indeed, a recent survey of European pension schemes showed less than 30 per cent have exposure to EMD.2

Growth of the asset class

Figure 1: The EM debt stock by asset class (US$ trillions)
Source: Bank of America Merrill Lynch, data as of December 31, 2020

EM investible assets have grown, broadened and matured considerably in the past twenty years. From what started in the early 1990s as a predominantly hard-currency bond market, EM debt is mostly now in local-currency form.

EM debt is mostly now in local-currency form

The tradeable EMD stock has seen a massive increase over this period, from around $2 trillion in 2000 to around $34 trillion in 2020. This reflects the growing maturity of government and corporate borrowing patterns, with local currency bonds by far the largest component at $29.4 trillion. The hard-currency segment is around $4.6 trillion for sovereigns and corporates combined. By way of context, the combined size of the DM government and corporate bond markets is $148 trillion.

As fixed income assets in developed markets offer low prospective returns, global demand for EMD has been strong – though DM exposure remains concentrated in hard-currency bonds.

A diverse set of assets and return drivers

EMD can offer value through diversification. For example, local-currency EMD has a low correlation with US Treasuries and a relatively low correlation with developed market corporate bonds and high-yield debt.

Hard-currency and corporate EMD have a slightly higher correlation with US Treasuries

By contrast, hard-currency and corporate EMD have a slightly higher (but still low) correlation with US Treasuries but a lower correlation with equity markets. Furthermore, there is great variety in correlations of the sub-components of EMD. For example, A-rated and corporate hard-currency EMD are less exposed to credit risk and more sensitive to movements in US Treasuries. These differences make EMD a flexible set of assets, whose exposures can be adjusted depending on the prevailing market environment.

EMD is often viewed as a single asset class. In reality, it is a combination of three separate asset classes, each with their own investor base and return drivers. 

Hard-currency debt is similar to DM corporate debt, with returns directly influenced by movements in US interest rates alongside investors’ assessment of the creditworthiness of issuers. 

Definitions

Hard-currency sovereign

Sovereign and quasi-sovereign (state-owned or partially state-owned companies) debt issued in external (hard) currencies, predominantly US dollars but also euros. Debt issued is subject to US or European law.

Hard-currency corporate

Debt by companies domiciled in emerging markets issued in external currencies, predominantly US dollars but also euros. This is viewed as the most defensive part of the EM market, given the higher credit quality and shorter duration of the debt.

Local-currency debt

Debt issued in the local or domestic currency. Debt is subject to local legal rules and interpretation. This is the most growth-sensitive EMD asset class given the currency component of returns.

Local-currency bond yields are a function of domestic rather than US interest rates, with local inflation and the exchange rate being the key influences. The addition of currency risk makes local EMD more volatile than hard currency.

Figure 2: An overview of the EMD universe
An overview of the EMD universe
Source: Aviva Investors, BRS Aladdin, as of June 30, 2021

Favourable default rates 

One of the common misconceptions about EMD is that default rates are significantly higher than their DM equivalents. In fact, defaults for the high-yield component of sovereign EMD has been broadly similar to US high yield, while defaults for EM HY corporates are significantly lower, as the table below shows. For local-currency and DM sovereigns, defaults are less of a concern as issuers can always print more currency if needed.

Figure 3: Historic default rates (per cent)
Historic default rates
Source: Aviva Investors, JP Morgan, data as of December 31, 2020

Yield and spread advantage

Despite the similar default experiences to DM credit, EM has tended to trade at a higher spread or yield to comparable DM issuers. In part, this premium can be understood by the difficulty investors face in assessing the ability and willingness, of issuers to repay their debt. The consistent cheapness of EM versus DM credit spreads can be viewed as an overestimation of this risk relative to realised defaults.

Figure 4: EM spread premium versus DM markets (investment grade)
Note: Does not depict any Aviva product or strategy.
Source: Aviva Investors, Barclays, as of October 31, 2021
Figure 5: EM spread premium versus DM markets (high yield)
Note: Does not depict any Aviva product or strategy.
Source: Aviva Investors, Barclays, as of October 31, 2021
Figure 6: Local currency risk premium versus US Treasuries (yield in per cent)
Source: Bloomberg, data as of June 30, 2021

Both local interest rates and views of local inflation tend to be higher in emerging economies, meaning local EMD has offered a persistent yield pick-up over DM government bonds.

Attractive returns?

Historic risk-adjusted returns for EM compare favourably to DM fixed income and equities, as Figure 6 highlights.

Figure 7: Major indices  Sharpe ratio
Major indices – Sharpe ratio
Source: Bloomberg, data as of June 30, 20213

Looking at total returns, EM hard-currency sovereigns have outperformed US high yield over the past decade, while EM corporates have outperformed US investment-grade credit.

EM sovereigns have enjoyed a period of relatively low default rates that, alongside falling risk-free rates and unconventional monetary policies such as quantitative easing, have helped keep global yields low and supported returns for the asset class.

Why EMD, why now?

  • Once investors move past outdated misconceptions that have prevented them from allocating capital to this asset class, EMD can be a useful addition to portfolios as DM yields continue to trade at or near historical lows.
  • EMD can offer important diversification within a broader global bond portfolio, as the asset class has traditionally had low correlation to US Treasuries. The investible universe within EMD has grown significantly in the past twenty years, offering a wide array of opportunities in local and hard currencies.
  • While EMD is typically more volatile than DM IG or sovereign debt, investors have been well compensated for this on an absolute and risk-adjusted basis.
  • Investors seeking a truly diversified portfolio and the prospect of higher long-term returns should consider adding exposure to emerging markets, which are too big and dynamic to overlook. The improving fundamentals occurring within many EM countries also support the investment case.

References

  1. Bloomberg Barclays Multiverse Index
  2. Mercer European asset allocation insights 2020
  3. CEMBI refers to J.P. Morgan CEMBI Broad Diversified Core Index for hard currency Corporates. EMBIG: J.P. Morgan EMBIG Global index for hard currency sovereigns. EM Local refers to JP Morgan GBI-EM Global Diversified for local currency sovereigns

Key risks

For further information on the risks and risk profiles of our funds, please refer to the relevant KIID and Prospectus.

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency and exchange rates. Investors may not get back the original amount invested.

Emerging markets risk

The funds invest in emerging markets; these markets may be volatile and carry higher risk than developed markets.

Derivatives risk

The funds may use derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.

Credit risk

Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.

Illiquid securities risk

Certain assets held in the funds could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

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