In the intricate landscape of global investing, emerging market debt stands as a compelling asset class. It’s a unique nexus of diversification, yield, and potential returns. Yet, an active management strategy is crucial to unlock its full potential. We discuss the depth and breadth of emerging market debt with our experts Michael Vander Elst and Hugo Verdière, and offer a comprehensive understanding of the associated opportunities and risks. Let’s find out why this asset class warrants investors’ attention in the current investment climate.
WHY SHOULD INVESTORS CONSIDER THIS ASSET CLASS?
Emerging market debt offers a unique blend of diversification benefits, attractive carry, and the potential for strong returns. Its addition to a portfolio provides access to an entire investment universe largely unsynchronised with developed market assets.
However, an active approach is required to fully reap the rewards offered by this asset class. It’s important to note that a lot of countries in this asset class are not included in benchmark indices. This can severely limit these indices’ diversification benefits. Our active approach means we are not limited to just the largest emerging economies and enables us to invest in frontier markets, broadening our scope and allowing us to target interesting and lucrative opportunities on a case by case basis.
However, investors should be aware that frontier markets can have liquidity issues due to their limited financial infrastructure. These smaller markets often lack the institutional strength and financial infrastructure of more established economies. They don’t always have a robust banking sector or well-established institutional pension funds. But here too, active management plays a vital role in addressing such challenges by researching, understanding, and anticipating these risks.
Another key differentiating factor in emerging markets is the information premium. Frontier markets in particular are often under-covered or completely overlooked by analysts, resulting in a lack of readily available information for investors. As a result, two countries with the same credit rating on paper could have vastly different risk profiles in reality. To really understand these nuances, investors and analysts need to conduct in-depth research and even travel to these countries for a first-hand experience. This boots-on-the-ground approach can reveal insights and opportunities that external analyses simply cannot provide. Leveraging this information premium can help investors to further enhance the value of their emerging market debt portfolio.
In short, an active approach to emerging markets enhances portfolio diversification, offering very attractive yields at a reduced overall risk profile.
WHY SHOULD INVESTORS CONSIDER THIS ASSET CLASS TODAY?
Emerging market central banks commenced their tightening cycles earlier than their developed market counterparts. Many – especially in Latin America – are likely to ease at upcoming meetings, with Costa Rica and Uruguay having already cut rates, thus rewarding bondholders. By contrast, developed market central banks are unlikely to ease monetary policy until at least 2024.
Furthermore, attractive pricing means it is now a favourable time to invest in emerging markets. Discounts and spreads (against developed market assets) are elevated relative to historical levels generally across the board; many emerging market economies are offering double digit yields. Foreign investor participation in these markets is also at a historical low, suggesting ample room for growth.
Along with potential tailwinds from further US dollar softening and the reopening of the Chinese economy, we believe these factors will deliver a strong year in emerging market debt. Potential downside drivers, largely relating to global investor sentiment, appear to be easing after the shocks of 2022; bear in mind how quickly risk appetites returned after the COVID shock of early 2020.
OPPORTUNITIES IN HARD CURRENCY AND LOCAL CURRENCY
Hard currency, including widely accepted currencies like the US dollar or Euro, is easily convertible and extensively used in international trade. In contrast, local currency is predominantly used for domestic transactions in a particular country or region.
Each currency type has its own advantages and disadvantages. Hard currency bonds mainly expose investors to credit risk, while local currency bonds carry predominantly currency risks, i.e. the risk of currency depreciation. As local currency tends to have limited acceptance or convertibility outside its borders, hard currency bonds tend to react more rapidly to shifts in risk sentiment due to their broader investor base.
Conversely, local bonds often benefit from the support of the local banking sector, which is motivated to hold longer-dated bonds during sell-offs as they have liabilities in the same currency. Local banks may also be legally obligated to allocate a portion of their funds to their government’s securities.
The choice between hard and local currency bonds ultimately relies on an investor’s risk appetite and their desired exposure to various market risks.
WHY IS AN ESG APPROACH SO IMPORTANT IN THIS ASSET CLASS?
Sustainability plays a crucial role in the emerging market investment process. Good governance and strong macroeconomic performance are closely intertwined, creating an essential dimension for evaluating investments. This makes sense given that strong institutions, well-established procedures, and constitutionally anchored fiscal rules contribute to stability. Decentralised power and a focus on the well-being of the population and future generations can help prevent conflicts and limit long-term investment risks.
It is also worth noting that emerging market economies are increasingly addressing sustainability through specialised financing tools such as environmental, social, and sustainable-linked bonds. These are very positive developments as an emphasis on sustainability in emerging market investments not only ensures long-term stability but also encourages foreign investment.
This is why we rely on our proprietary quantitative sustainability model – based on over 50 criteria – to determine the ESG-profile of countries in which we consider investing. This model, which has been in use for over a decade, already incorporated sustainable development goals before they were pushed by the United Nations.
HOW HAS THIS ASSET CLASS EVOLVED IN THE LAST 10 YEARS?
Over the past decade emerging markets have developed significantly as an asset class, driven by several key factors. First of all, the size of the market has expanded rapidly over this time period, barring last year’s exception due to market volatility. This growth is particularly evident in local currency bonds, facilitated by the increasing sophistication of national debt management offices and securities markets.
Second, there has been a marked improvement in emerging market institutional quality. This largely stems from increasing technical support from multilateral institutions, which has driven improvements in data availability, policy development and overall engagement with investors. These enhancements have provided investors with a more stable and reliable investment environment.
These improvements are best exhibited by the stability of the asset class relative to historic periods of aggressive monetary tightening: stresses have only emerged in individual sovereigns with long heralded weaknesses, such as Bolivia, Ghana, Pakistan and Sri Lanka. There are no systematic threats developing that could fell entire regions, such as what we saw in Latin America in the 1980s or Asia in the 1990s. Improved macroeconomic stability will pave the way for further growth and development as current external shocks ease, and support the asset class’s growing attractiveness to investors.
