What Makes Emerging Market Debt Tick?

The 2018 CFA Institute Latin America Investment Conference will be held in Rio de Janeiro on 1–2 March. This practitioner-oriented educational conference will focus on Latin American economies and capital markets, as well as global issues relevant to investors worldwide.

Asset allocators and wealth managers are always on the lookout for new asset classes, or beta opportunities, as a way to enhance portfolio risk and return. The ideal beta opportunities are those that offer high return, low risk, and low correlation with other assets in the portfolio. Over the last decade, emerging market debt as a group seems to have done just that, so no surprise then that it started gaining popularity as a fixed-income asset class in recent years.

How did the emerging market debt market develop and what makes emerging market debt tick? The asset class consists of three types of bonds: (1) sovereign debt issued in major currencies, mostly the US dollar, (2) sovereign debt in local currencies, and (3) corporate debt in major currencies, mostly the US dollar. Let’s take a closer look at each one of them.

The first emerging market bonds were US dollar–denominated sovereign debt. They came into existence as a way for lenders to recoup some of their defaulting loans to Latin American countries in the late 1980s. The efforts became known as the Brady Plan, after then US Treasury Secretary Nicholas Brady, who led the initial negotiations. Mainstream investors shunned Brady bonds for a long time due to their not-so-glamorous roots and the resulting below-investment grade ratings. Being US dollar-based, the bonds trade off the US Treasury yield curve as a “spread product,” i.e., their return should offer investors additional compensation over US Treasuries for the extra risk involved. Specifically, this extra risk for US dollar-denominated sovereign debt is country risk, largely driven by the fiscal conditions of emerging market countries. To put it simply, these governments had to pay more to borrow from bond investors than the US Treasury because the market thought they were borrowing more than they could easily repay given their respective tax base.

Mainstream investors have warmed up to emerging market debt over the last decade, especially after the global financial crisis that peaked in 2008. According to data from the Bank for International Settlements and International Monetary Fund, half a trillion US dollars in foreign investments flowed into the emerging market government debt segment in 2010–2012 alone. The backdrop of this growth was the improving fundamentals of the emerging market economies. Starting in 2003, Mexico and a host of other countries retired all their Brady bonds. In 2008, Brazil was upgraded to investment grade while developed markets led the world economy into the global financial crisis. In contrast to developed markets, emerging market economies exhibited stronger growth and healthier fiscal conditions. Recent data suggest that central government debt as a percentage of GDP has generally been healthier in the emerging market economies compared to developed markets.

Over this period, local currency sovereign debt issuance grew much faster than US dollar–denominated sovereign debt. In addition to country risks, local currency sovereign bonds are also exposed to currency risks. Improving balance of payments and rising reserves allowed emerging market countries to borrow in their local currencies. Healthy economic growth also created expectations for emerging market currencies to appreciate against the US dollar. As a result, the local currency sovereign debt market expanded much faster.

US dollar–denominated corporate debt was the fastest-growing segment in emerging market debt over the last decade. Major emerging market corporations have been significant drivers and beneficiaries of the rapid growth of emerging market economies. The additional risk that this segment is exposed to compared to US dollar–denominated sovereign debt is corporate credit risk. Improving corporate balance sheets and strong growth prospects propelled the corporate debt segment to grow from about 50% of total emerging market debt issuance in 2003–2004 to about 80% in 2012–2013. McKinsey Global Institute estimates that companies in the emerging markets are likely to account for 40–50% of the Fortune Global 500 by 2025, up from just 5% during the period 1980–2000, so the growth trend for this segment is likely to continue.

In summary, the factors that make emerging market debt tick are:

1. country risk, mostly driven by fiscal conditions, i.e., internal balances as it is often known,
2. currency risk, driven by balance of payments or external balances and the resulting reserve positions, and
3. corporate credit risk, i.e., company balance sheets.

On all counts, emerging markets appear to have outdone developed markets over the last decade. As a result, investors in emerging market debt have been nicely rewarded over this period, with yields of investment grade debt in all three segments consistently beating their developed market peers. Domestic investors have increasingly become important players in this market too. Will Oswald, global head of FICC research at Standard Chartered, believes domestic insurance companies, mutual funds, and pension funds have become important investors in emerging market debt in recent years as well, thanks to their rapid growth and their asset allocation needs.

As is the case with all investments, though, investing in emerging market debt is not without market risks. As more investors started to recognize the value of this “new” asset class, changing macroeconomic conditions, namely the tapering of QE3 by the Federal Reserve and the strong US dollar, caused havoc in the emerging market debt market in 2013. Does this represent an opportunity for beta investors? Are there other ways to benefit from this market? For example, if you like the debt of certain countries and sectors better than others, or would prefer to avoid certain countries or sectors, how could you reflect your preference through beta products such as index funds and ETFs? How are you supposed to go about assessing the attractiveness of various countries or sectors? I will address these questions in a follow-up post.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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