Insights

Case for Emerging Market Debt

EM debt offers portfolio diversification, higher yields, and exposure to relatively strong economic growth. Is now the time to consider an allocation?

June 16, 2023

Desmond Lawrence

Senior Investment Strategist

An inflection point may be near in the emerging market debt narrative. Having faced the combined headwinds of a seemingly ever-stronger US dollar, a major sell-off in advanced economy bonds, and a string of high-profile defaults through 2022, there is a solid case to be made that the worst of the news and deterioration in fundamentals may now be in the rear-view mirror. The outflow of funds from emerging debt markets has slowed considerably against this backdrop and amid expectations of an improving economic landscape. Our recent article, Revisiting EMD: Brighter Days Ahead? provides additional insight on the market’s recent trajectory and outlook.

Fundamentals

The emerging market debt universe is diverse, there are headline risks and idiosyncratic factors that mean the asset class is not necessarily suitable for the risk-averse investor. But for those willing to embrace this medium risk fixed income exposure, the prospects are starting to look more favourable.

Historically, emerging economies have generally grown faster than developed markets. That outperformance narrowed through the pandemic period, but is expected to widen again – the International Monetary Fund has forecast that emerging market economies will expand by 3.9% in 2023 and while that is slightly slower than the 4.0% growth in 2022, advanced economies will only grow by 1.3% (compared to 2.7% in 2022).¹
Further substantial falls in inflation should provide cover for the US Federal Reserve to cut rates in the latter part of this year. This in turn can alleviate and reverse the pressures arising from a strong dollar, especially for hard currency EM debt. Fundamentals are also moving in the right direction: for those EM countries struggling with heavy debt burdens, most have either restructured their debt or the market has priced for such a scenario. So after two record years of restructurings, the EM hard currency segment is better positioned and tail risks have been reduced.
The prospects for local currency emerging market debt are also attractive. A potential peak in the US dollar and the reopening of China are potential favourable supports. An added dynamic in the local currency arena comes from domestic monetary policy. A number of emerging market central banks commenced the rate hike cycle well ahead of their developed counterparts and as a result some (Brazil and Mexico, for example) have pushed real policy rates well into positive territory.
Elevated real rates should choke back inflation and provide investors with substantial potential for yield curve steepening as rate cuts begin to be priced in. Not all nations are at this point yet and some — notably Central and Eastern European countries — may take a bit longer for the disinflation trend to follow through.
China’s removal of most pandemic-era restrictions removes a headwind for key trading partners across Asia and adds support to the emerging markets universe in 2023.
Deepening local markets increasingly allows EM borrowers to meet much of their funding needs without resorting to issuance in foreign currencies, thus helping to mitigate the impact of rising US rates on EM borrowing costs.
Geopolitical risks remain. The Russia-Ukraine War has weighed heavily on sentiment towards Emerging Europe given geographical proximity and the many close trade and energy links with both countries. Heightened tensions between the US and China over Taiwan, China’s tacit support for Russia, and technology-related issues are also simmering.

Valuation

Hard Currency: EMD returns have reversed some of the sharp sell-off that was seen through much of 2022. In hard currency EM debt, high yield spreads were largely responsible for driving overall spreads wider. However, most of the vulnerabilities have already been exposed and been largely baked in to the price. Even with the improvement in risk appetite, and spread volatility may still be a feature, it seems unlikely that spreads would detract in a meaningful way through the rest of 2023. Furthermore, the potential for more US Treasury volatility remains although movements in spreads and Treasuries may well offset each other.

The key pillar of the case for hard currency EM debt is carry. With a yield of about 8.5%² , the asset class presents a healthy opportunity for income-seeking investors.

Local Currency: Valuations in the local currency EM debt space are arguably more appealing. The greater source of performance will likely come from the rates component. EM central banks started hiking rates up to a year ahead of the US Federal Reserve; average EM inflation appears to have peaked and some EM central banks have already hit ‘pause’ on the rate hike front, with some expected to start cutting rates later this year. Local currency EM yields are close to double those of global aggregate bonds³ , thereby providing attractive yield enhancement potential.

EM FX remains slightly undervalued versus the euro⁴. Buying the basket of EM currencies when undervalued can add to the attractiveness of the overall proposition.

Geopolitical risk is not insignificant but is arguably well compensated for by high nominal and real yields.

Technicals

Investor positioning and flows may also be turning into less of a headwind. Over 2022, net flows pertaining to hard and local currency funds were -$44.3bn and -$45bn, respectively. That improved dramatically over the course of the first quarter of 2023, although flows out of both hard currency and local currency continued – albeit at a slower pace. Further improvement in sentiment was evident in April with net flows for hard currency and local currency funds running at -$1.5bn and -$0.2bn, respectively. (See Figure 2).

The Role of EM Debt in a Portfolio

We believe that EMD deserves consideration in a diversified investment portfolio. The asset class offers good growth exposure with moderate correlation to both DM equities and bonds – see historic asset class correlations table below. Equity investors can enhance overall portfolio efficiency and drawdown mitigation with an allocation to EM debt, while bond investors may capture significant yield enhancement.

The different EM debt segments combine well – a simple equal weighting approach is a reasonably efficient allocation of capital. However, portfolio efficiency can be further tuned with optimised allocations. Historically, a heavy tilt towards hard currency sovereign and corporate debt would have been the most efficient allocation to EMD. However, the current outlook argues that a greater role for local currency bonds is warranted in an optimal EMD portfolio.

Figure 3: Emerging Market Debt Correlations

	EM HC Sovereign Debt	EM HC Corporate Debt	EM LC Sovereign Debt
EM HC Sovereign Debt	1.00	0.93	0.71
EM HC Corporate Debt	0.93	1.00	0.61
EM LC Sovereign Debt	0.71	0.61	1.00
MSCI All-Country World Index	0.52	0.47	0.57
MSCI World Index	0.52	0.47	0.53
MSCI Emerging Marks Index	0.42	0.36	0.65
Global Aggregate (Hedged)	0.42	0.28	0.33
Global High Yield Index	0.85	0.84	0.63

Source: State Street Global Advisors, JP Morgan, Bloomberg Finance L.P., MSCI as of 31st December 2022. Correlations are calculated using returns from Jan 2003 – Dec 2022 in euro currency terms. JP Morgan EMBI Global Diversified Index for Hard Currency EM Sovereign; JP Morgan CEMBI Broad Diversified Index for Hard Currency EM Corporate; JPM GBI-EM Global Diversified Index for Local Currency EM Sovereign; MSCI All Country World Index for MSCI ACWI; MSCI World Index for MSCI Developed World; MSCI Emerging Markets Index for MSCI EM; Bloomberg Global Aggregate for Global Aggregate; and Bloomberg Global High Yield for Global High Yield.

The Bottom Line

As noted, we may be at an inflection point where some of the bigger challenges that faced EM debt are now fading and generally solid fundamentals now come to the fore. The asset class is not without headline risk and investors need to appreciate the idiosyncratic nature of the different country exposures. However, EMD can offer diversification for both equity and conventional bond investors at a point where both hard currency and local currency yields are near historically attractive levels.

Investor flows may also point to a fading headwind – after substantial net outflows in 2022 the pace has fallen dramatically in the opening months of this year.

Disclosure

Marketing communication

State Street Global Advisors Worldwide Entities

Web: www.ssga.com

The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This communication is directed at professional clients (this includes eligible counterparties as defined by the Appropriate Regulator) who are deemed both knowledgeable and experienced in matters relating to investments. The products and services to which this communication relates are only available to such persons and persons of any other description (including retail clients) should not rely on this communication.

Past performance is not a reliable indicator of future performance.

Investing involves risk including the risk of loss of principal.

Index returns reflect capital gains and losses, income, and the reinvestment of dividends. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses associated with the fund or brokerage commissions associated with buying and selling a fund. Index performance is not meant to represent that of any particular fund.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond values and yields usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. Investing in high yield fixed income securities, otherwise known as junk bonds, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.

Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.

Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Currency Risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

Diversification does not ensure a profit or guarantee against loss.

All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

The views expressed in this material are the views of Desmond Lawrence through the period ended 31 May, 2023 and are subject to change based on market and other conditions. This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analyses made by SSGA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSGA's control. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.

The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.

Footnotes

More on Fixed Income

View all Insights