Diversification
The investment case for emerging market debt
4 min read 9 Apr 24
This is for information only. It is not advice.
Our models hold a higher allocation to emerging market debt than our peers. Emerging market debt has historically been a volatile asset class. However, we believe its risk profile has decreased due to the positive economic strides made by emerging market countries over the past two decades. In this article, we explain the changes that have occurred within emerging market debt and why we believe holding the asset class in investment portfolios is an attractive strategy.
More countries, more diversification
In 1992, the emerging market debt index consisted of just 10 countries. Most of these countries were in Latin America and had weak economies. Their economic stability was significantly influenced by changes in commodity prices, due to their dependence on commodity exports.
Today, around 80 countries are classified within the universe[1]. Countries with strong credit ratings (AA and A), which include Saudi Arabia and Qatar, now account for over 20% of emerging market bonds. These countries have improved the quality of the universe and given active managers more opportunity to increase diversification within their holdings of emerging market bonds.
1 Source: JPMorgan, JPM EMBI Global Diversified Index
Going local
Another change since the 1990s is that many emerging market countries have increased borrowing in their own currencies – often called ‘local’ currency debt. The alternative is to issue bonds in currencies such as the US dollar, Euro or Yen. If a country has significant debt in US dollars, then when a country’s currency falls, that debt becomes more costly to pay back.
This shift has given countries more control over their economic policies. For instance, they have been able to cut interest rates more freely to support the economy during recessions without worrying about weakening their currency against others.
Better economic management
Emerging market countries have also built-up additional currency reserves to safeguard against sudden currency movements. They’ve set targets for inflation to keep living costs stable and predictable. And they have permitted central banks to become more independent from governments, allowing decisions to be based on economic conditions rather than political factors. Thanks to these changes, their economies are more stable and inflation is much lower than it was back in the 1990s – as shown by the graph below
Emerging Economies vs Advanced Economies CPI inflation and IMF Forecast
Source: IMF, World Economic Outlook (October 2023)
Emerging market debt is well positioned in the current economic environment
In response to rising inflation, emerging market central banks were quick to react and raise interest rates. This kept inflation broadly under control and allowed central banks to cut interest rates earlier than other developed market economies. For example, Brazil’s Central Bank has recently lowered its interest rate for the sixth time in a row. As interest rates fall, bond prices rise in value and vice versa. We expect inflation to continue to fall in emerging market regions, providing more opportunity for central banks to reduce interest rates.
We expect GDP growth within emerging economies to be higher than developed economies in coming years. The difference in growth between emerging economies and advanced economies is predicted to reach an 8-year high in 2024[2]. Historically, this level of growth differential has been an important predictor of emerging market bond performance. Higher economic growth increases government revenues, making the repayment of debt easier.
2 Source: IMF, World Economic Outlook, October 2023.
Yields remain high and fundamentals are strong
Emerging market debt performed well in 2023. Despite this, yields remain high compared to the pre-Covid-19 era. As the US is expected to cut interest rates over the course of 2024, foreign investors may look for higher returns elsewhere. This would increase investment into emerging markets.
Emerging economies usually have less debt than developed economies. For example, the US household debt to GDP ratio is 63%, which is in stark contrast to Mexico’s ratio of 16.3%[3]. In a world with higher interest rates, lower debt levels mean less pressure on the ability to repay debt. For emerging market companies borrowing money, JP Morgan expects default rates to fall in emerging markets compared to last year[4].
3 Source: CEIC Data December 2023
Understanding the risks
Lower US interest rates would be a tailwind for emerging market debt. However, the US could maintain higher interest rates for longer than expected. This may lead investors to sell their holdings in emerging market bonds in favour of increasing returns in US bond markets.
Alternatively, if a global recession becomes more likely, this could cause investors to reduce investments in more risky asset classes such as emerging market debt in favour of safer asset classes like developed market government bonds. In emerging market debt local currency markets, we would see emerging market currencies come under pressure as investors rush to safe haven currencies like the US dollar.
There is a risk that countries within emerging markets could face bankruptcy. You may have recently seen Argentina facing potential bankruptcy difficulties on the news. Whilst bankruptcies of emerging market governments do occur, we take comfort in the fact that these countries are usually a small part of emerging market bond indexes. Countries also have more levers to pull to avoid bankruptcy than companies.
Positioning within porfolios
We think emerging market debt will deliver good returns relative to the risks in the long term. Better economic policies and the expansion of the emerging market debt universe have reduced the risk profile of the asset class over the years. Emerging markets are also further along in their interest rate cutting cycles, have better GDP growth prospects, and lower levels of debt compared to developed markets. The asset class also provides a source of diversification within investment portfolios due to emerging economies being at different stages of their economic cycle relative to developed economies.
Given how the asset class have evolved, we think this is a clear case where past performance is not an indicator of future performance.
Past performance is not a reliable indicator of future performance. The value of an investment can go down as well as up and your client may get back less than they’ve paid in.