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Emerging opportunities

Emerging market bonds deserve more attention. Their economies have proved resilient during the pandemic. Now that the global economic recovery is well underway, the outlook for this asset class has improved even more. In this article, our experts discuss how investors can gain exposure to emerging market bonds.

December 3, 2021

Emerging markets generate

60%

of global GDP

Emerging markets generate roughly 60% of the world’s gross domestic product. Their national economies are also still growing faster than developed market economies. Debt crises and currency shocks have become less common and no longer have the domino effect they once did.

Today, countries classified as emerging markets – in Latin America, Europe, Asia, and elsewhere – feature robust institutions and stable markets.

In parallel with their economic growth, emerging markets have also developed into a diverse and mature stand-alone asset class over the last 20 years. They have become an indispensable element of a diversified portfolio.

This is a story about resilience and the global economic recovery. The world’s emergence from the pandemic has unleashed pent-up demand for both goods and commodities. Subsequently, the outlook for emerging markets has improved significantly, benefiting emerging market bonds.

It is worth noting, however, that emerging market bonds are not a single asset class. Rather they are a collection of different asset classes, which include both corporate and sovereign bonds and can be invested in both hard currency – US dollars and euros, for instance – and local currency. Both asset classes require a different approach to gain efficient and effective exposure. On the one hand, active selection when managing credit risk is important for emerging market corporate bonds, while on the other hand, diversification is a more pressing issue for emerging market sovereign bonds.

Emerging market corporate bonds

When it comes to emerging market corporate bonds, careful credit selection is incredibly important. Emerging market companies have seen their earnings improve, which has allowed them to deleverage and strengthen their balance sheets. Subsequently, they have been able to lengthen the maturities of the bonds they issue because their credit quality has improved. Leverage ratios have started to fall after they increasing in 2020, and they are expected to fall to levels last seen in December 2019. This would indicate that the risk of default has declined from last year.

Emerging market corporate bonds on average also offer a higher yield than credit with the same rating in developed markets.

Each emerging market country is also unique. They differ from each other in terms of their economic fundamentals, which has an impact on their individual credit markets. Consequently, the opportunities available to investors are incredibly diverse. This is a market where active selection can really pay off. There are many potential rising stars among emerging market corporate bonds, but at the same time prudent selection to avoid the potential fallen angels is also needed. Meanwhile, in the more mature emerging market sovereign bond market, the opportunity lies in being able to get diverse exposure across the asset class.

US Corporate HY
EM Sovereign
Sources: Bloomberg, J.P. Morgan Indices

1 The Sharpe Ratio helps investors understand the return of an investment compared to its risk.
* The yield to maturity shown is calculated as of May 31, 2021 and does not take into account costs, changes in the portfolio, market fluctuations, and potential defaults. The yield to maturity is an indication only and is subject to change.

Emerging market sovereign bonds

According to Valerio Schmitz-Esser, Head of Index Solutions at Credit Suisse Asset Management, “diversification remains one of the most important protective measures for investors when investing in emerging market sovereign debt.” He continues by explaining that “this is where the benefit of using an index fund to gain exposure to this asset class can really make a difference as these products are well diversified, low-cost, and easy to use.”

Let’s look at an example. In 2020, there was a record number of sovereign defaults. For example, Zambia, Ecuador, and Argentina all defaulted. However, index funds that track broad emerging market sovereign bond indices felt little impact. These include, for example, those that track the J.P. Morgan Emerging Markets Bond Index Global Diversified. The individual index weightings for these countries represented only a small portion of the index portfolio, which contains bonds issued by more than 70 countries.

"Diversification remains one of the most important protective measures for investors when investing in emerging market sovereign debt." Valerio Schmitz-Esser, Head of Index Solutions

Emerging market debt is underrepresented in most portfolios

Yet despite the benefits that both emerging market credit and emerging market sovereign bonds can offer, many investors remain underexposed. “Emerging economies account for more than half of global GDP, yet the amount that global portfolios allocate to this sector remains very low,” explains Schmitz-Esser.

In recent years, however, allocations to these asset classes have started grow. This is partly because the emerging market debt universe is growing, which has justified the increase in the allocations made by investors. By having the right mix of actively managed emerging market credit funds and index funds, investors can allocate more efficiently. The different risk premiums offered by both can be extremely useful for portfolio construction.

Schmitz-Esser believes that “hard currency index funds are particularly attractive due to the low costs of hedging any currency risk in euros.”

The reference index his team favors is the J.P. Morgan Emerging Markets Bond Index Global Diversified (EMBI) in hard currency. This index employs a cap of 5% per country, which Schmitz-Esser believes helps limit the concentration of specific issuers within the index.

Although bonds in local currencies allow investors to benefit from slightly higher yields, the volatility of emerging market currencies must also be taken into consideration. In some situations, this risk could pay off. China is a good example because its role in the global economy is becoming increasingly important, which bolsters demand for its currency.

China’s presence is also being felt in index compositions. Starting from the end of October 2021, Chinese renminbi sovereign bonds will gradually be incorporated into the FTSE World Government Bond Index (WGBI). In the 36 months that follow this event, the weighting of Chinese government bonds within the index is expected to rise to over 5%. This should also help increase the allocations made by global investors to emerging market bonds.

Setting sights on corporate bonds

The reason why emerging market corporate bonds are so attractive is because of the irregular structure of this market. This creates opportunities for investors. “In this market, added value can be generated by actively selecting bonds and managing duration,” explains Gonzalo Borja, Head of Fixed Income Emerging Markets at Credit Suisse Asset Management.

Borja goes on to explain: “At the moment, we see better opportunities in corporate bonds issued in hard currencies. They feature a significant spread relative to both the investment grade and high yield bonds in developed markets.” 

"In this market, added value can be generated by actively selecting bonds and managing duration." Gonzalo Borja, Head of Fixed Income Emerging Markets

The investment grade segment in the US received support from the US Federal Reserve over the past year and achieved a yield of roughly 2%. Comparable bonds from emerging markets, on the other hand, have shorter durations – five years on average – and yields that are 80 to 100 basis points higher. According to Borja, based on the JPM CEMBI broad Diversified Index, “when we compare European investment grade bonds with hard-currency emerging market credit, there is a difference of roughly 100–120 basis points for the same borrower quality after hedging cost.”

In the past, emerging market sovereigns were preferred because corporate bonds had a relatively small market cap. For dynamic asset allocation, the focus was on local currencies. The situation, however, has now changed due to the influence of loose central bank monetary policy. Higher US Treasury yields have put pressure on government debt in emerging markets and made corporate bonds more competitive. Their characteristically short durations also allow for a more flexible response to changing spreads.

In terms of the risk/return ratio, emerging market bonds in hard currencies have a much better profile than European and US corporate and sovereign bonds. The opportunities are there. You just need to recognize them and take advantage of them.

 

The bigger picture

The most important attributes of successful investors include the ability to capture the determinants as a whole and link them together. This produces the big picture. It shows the entire investment spectrum and creates transparency to make investment decisions easier.

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Risk warning
Bond markets carry risks of issuer default and are subject to economic and market fluctuations. Emerging markets can be prone to more pronounced moves than developed markets, including to the downside.

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