• Fixed Income
  • Emerging Market Debt
  • Emerging Markets

Standing tall

Three factors behind the resilience of emerging-market debt

In this article, we explore what’s behind emerging markets’ impressive performance in the face of global economic volatility, and investigate how EM debt investors can take advantage.

Read this article to understand:

  • The newfound strength of high-yield sovereign issuers
  • How structural reforms have enhanced economic stability across emerging markets
  • The robust fundamentals of EM companies

In the investment world, it’s always worth challenging the accepted wisdom.

The conventional view of emerging markets (EM) is that they are more economically vulnerable than their developed-market counterparts. While that may hold broadly true, the increasing strength and impressive growth prospects of many EM nations may warrant a second take.

Aviva Investors’ EM debt team uses a proprietary “vulnerability model”, which measures key credit metrics such as budget deficits, interest costs and external financing requirements. We thought it would be fun to run a behemoth like the US through the model to see how the world’s biggest economy ranks next to the EM countries we usually track.

The surprising result? If the US were an emerging market, it would win first prize for the most vulnerable economy in the category (see Figure 1). With a budget deficit of eight per cent and public debt at over 100 per cent of GDP, the US looks weaker than many EM nations on key fiscal indices, despite the relatively low yields on Treasuries. For example, Saudi Arabia’s debt stands at a meagre 27 per cent, while debt in Peru, Indonesia and Azerbaijan is below 40 per cent of GDP.

The EM universe is growing more robust even as advanced economies face pressing challenges

Of course, the US has big advantages that offset these issues. The size of the US economy and the role of the dollar as a reserve currency clearly makes it very different from emerging economies. But the exercise does illustrate an interesting point – the EM universe is growing more robust even as advanced economies face pressing challenges.

In this article, we pick out three key reasons for EM countries’ growing resilience and explore how investors can take advantage of opportunities across the vast universe of EM debt.

Figure 1: The vulnerability index – US versus EM

Source: Aviva Investors. Data as of May 2024.

The high-yield market bounces back

One indication of the increased resilience across EM economies is the fiscal strength of high-yield issuers, traditionally the weaker economies in the universe.

This is partly a cyclical story. Many of these countries have benefited from elevated commodity prices over recent years, which has helped them to sharply narrow their current account deficits (especially in Sub-Saharan Africa).

A fall in commodity prices would cause problems for some of the weaker high-yield issuers; while reserves are higher at this point, they may not be sufficient to provide protection should commodity prices stay low over an extended period. On the plus side, countries that have shown improved fiscal discipline should be in a better position as and when new macroeconomic headwinds materialise. 

Figure 2: Change in primary budget balance, weighted by credit rating category

Source: IMF, Macrobond, Aviva Investors. Data as of August 2024.

Many of these economies have successfully consolidated their primary budget balances back to their pre-pandemic levels

For example, many of these economies have successfully consolidated their primary budget balances back to their pre-pandemic levels, a significant achievement given the public expenditures required during the COVID-19 outbreak and the broader fiscal challenges posed by higher interest costs during the subsequent monetary tightening cycle.

Kenya, for example, has shifted to running a primary surplus over the past year, something which hasn’t happened before over the past decade. South Africa has also shifted to a primary surplus for the first time in 15 years, as the government pushed ahead with a conservative fiscal policy despite a challenging growth outlook. Argentina, a serial defaulter, finally has a government in place that understands that fiscal imprudence has contributed to the country’s regular “boom-bust” cycles.

By raising new debt, countries such as Ivory Coast and Benin have been able to rebuild their reserves

Reflecting this, high-yield issuers have been able to return to the international markets to issue bonds in 2024. By raising new debt, countries such as Ivory Coast and Benin have been able to rebuild their reserves, and we expect Nigeria and Senegal to follow suit by tapping markets over the coming months.

Understanding which countries are likely to adopt proactive fiscal policies and maintain their discipline in a more adverse macroeconomic environment will be key in picking the winners. Our forward-looking assessment of debt dynamics through to 2029 suggests high-growth, high-yield countries, like Egypt, should see debt fall further. However, we need to pay particular attention to credits like South Africa, whose fiscal improvements could be unwound if growth disappoints, or interest rates remain elevated. Slow-growth countries like Brazil also warrant careful focus, particularly if domestic politics remains disruptive, and local bond yields remain elevated. 

Figure 3: Public sector debt dynamics (per cent of GDP, 2025-2029)

Source: IMF, Macrobond, Aviva Investors. Data as of August 2024.

Structural resilience

The structural improvements in EM economies are another important factor in the resilience of these markets.

Emerging economies have strengthened their monetary policy frameworks

As well as improving their fiscal discipline and bolstering their revenue-collection capabilities by rolling out new technology, many emerging economies have strengthened their monetary policy frameworks, with central banks shifting towards inflation-targeting regimes and greater exchange-rate flexibility. EM central banks, in many cases, led the charge in recognising that inflation was less transitory than initially thought from mid-2022 onwards, raising rates and taming inflation ahead of their developed-market counterparts (see Figure 4).

Figure 4: DM versus EM policy rates

Source: Macrobond, Aviva Investors. Data as of August 2024

Countries like Egypt, Nigeria and Sri Lanka are transitioning toward more flexible foreign-exchange regimes after learning hard lessons in previous years when they struggled with depleted reserves. Others, like Ghana and Kenya, have been operating with more flexible regimes for some time. In addition, stronger prudential regulation and supervision at both national and international levels introduced since the Global Financial Crisis means the broader macro framework is more stable than in the past.

Looking ahead, longer-term structural trends, such as the likelihood of sustained demand for critical materials needed for the net-zero transition, could further enhance the economic security of emerging economies. Many critical raw materials needed for the transition are sourced from EM nations such as Chile, which is a major exporter of copper, a key component in electricity transmission networks.

Strong corporate fundamentals

It is no secret that EM corporate giants such as Indian telecoms firm Reliance Jio and South African internet company Naspers are wielding increasing clout on the global stage.

One indication of the resilience of EM companies is that default rates are on the decline

But the broader resilience of EM companies is also worth noting. One indication of this is that default rates are on the decline: JPMorgan recently revised its 2024 default-rate expectations for high-yield companies across the Corporate Emerging Market Bond Broad Diversified Core Index to 2.1 per cent (down from 2.9 per cent). This marks the first time in four years when the default rate is projected to be below the historical average.

Prudent cash management and pragmatic corporate behaviour throughout a difficult period following the COVID-19 pandemic has been reflected in strong credit metrics among many EM companies.

EM companies have managed to maintain strong balance sheets and healthy credit metrics

While the tougher macroeconomic environment has contributed to a higher cost of capital – which is likely to have played a role in reduced merger-and-acquisition activity, lower capital expenditures and restrained shareholder returns – these factors have also enabled EM companies to maintain strong balance sheets and healthy credit metrics. 

Despite the inflationary pressures experienced during the 2023 financial year, earnings before interest, tax, depreciation and amortisation (EBITDA) margins fell by just one per cent across companies in the JPMorgan index, while gross and net leverage increased by a modest 0.2x and 0.1x over the period, respectively, attesting to strong discipline among EM companies.

Finding opportunities

Even as EM sovereign and corporate issuers appear increasingly robust, valuations continue to look attractive. Higher yields are available on EM debt following a significant repricing that took place in 2021 and 2022, potentially offering greater return potential and a cushion against future market volatility. 

Figure 5: Emerging market bond yields

Source: JP Morgan, Aviva Investors. Data as of February 2024.

Some investors have looked to cash and short-duration assets as “safe havens” during the recent macroeconomic uncertainty and market volatility. But the risk of reinvesting at lower rates looms, with policy rates expected to decline further. In this environment, and in the context of strengthening fundamentals, the relatively higher returns available on EM debt could prove increasingly attractive.

Investors will need to adopt an active, flexible and disciplined approach

Nevertheless, while we can point to increasing resilience across EM, there is great divergence across the universe, and risks to the asset class are arguably more dynamic in nature than those in developed markets. Investors will need to adopt an active, flexible and disciplined approach in order to identify the most attractive opportunities.

These opportunities exist across the entire investable universe – not just within the higher-yielding segments of the market towards which return-chasing investors often display a bias. We believe evaluating the full opportunity set across investment-grade and high-yield is a better way to capture the best prospects.

A deep understanding of risk is essential

A deep understanding of risk is also essential, because emerging markets are characterised by high levels of idiosyncratic risk, which traditional risk metrics often fail to fully capture. Expertise and comprehensive due diligence – including in-country visits to meet with key policymakers and other stakeholders – is crucial for a deeper understanding of each market and its place within the EM universe.

Finally, balanced portfolio construction is key to delivering consistent returns. Our process targets diversified sources of returns with a constant focus on risk and reward. We have a willingness and ability to avoid biases and focus on a broad range of opportunities that we fully understand because of the depth of our fundamental analysis (see “An unbiased approach to finding opportunities in emerging-market debt”).1  This approach offers potential to achieve a smoother path of strong risk-adjusted returns and can be attractive for investors seeking to build a strategic allocation to an asset class that, as the factors explored above show, is increasingly set up for longer-term resilience.

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Key risks

Investment risk

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.

Credit and interest rate 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.

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