What to pack
Emerging-markets debt is far from homogenous. Emerging-markets hard currency debt and local currency debt are two distinct asset classes with different credit quality and regional compositions. They each respond to varying return drivers. The same applies for emerging-markets corporate bonds and frontier bonds, which have their own characteristics. Investors looking to journey into emerging-markets debt may want to consider which of these to bring or add into their portfolios.
Those willing to buckle up for a long ride could be the first to broaden their horizons and take advantage of future opportunities.
Emerging-markets hard currency debt
Emerging-markets hard currency debt is the asset that started it all in emerging-markets debt. It is ultimately a spread asset. In other words, it is compared to the yields of developed-markets sovereign debt instruments and can offer attractive investments in a low-return environment. The emerging market spread (which measures the difference in yields between emerging-markets debt and U.S. Treasuries) is currently around 330 basis points (bps), as measured by the JP Morgan EMBI Global Diversified Index. Current valuations within this asset class have fared positively.
Emerging-markets hard currency bonds offer low correlation to developed markets and emerging-markets equities, which can be a valuable diversification tool in today’s uncertain global climate.
Emerging-markets local currency debt
Emerging-markets hard currency debt may have started it all, but emerging-markets local currency debt is now the leader in terms of market capitalization. This means investments in local currency debt tend to have a profound influence on the economy of its respective country. How can it accomplish this?
A domestic bond that is rising in value can support local economic growth. In turn, the country’s debt profile improves, making it easier for the government to borrow at lower costs. This eventually creates a healthy cycle of development for emerging-markets countries, and for investors in these markets.
Although increased volatility has made it a more difficult path for emerging-markets local currency debt over the past few years, emerging-markets local currency bonds have become an appropriate asset class for a wider range of investors because of their size, growing liquidity and dedicated research platforms.
Emerging markets corporate bonds
Corporate bonds in emerging markets have also been attracting investor interest. Both U.S. high yield and European high yield had strongly rallied with the yield on the core indices converging with the yield on emerging-markets corporate debt. This happened despite a higher average credit rating at BBB on the JP Morgan emerging-markets corporate debt index.
Relative value can also be found by comparing the spread differential against U.S. corporate debt with the same credit rating. Emerging-markets corporate debt has traded at wider spreads, despite having a lower overall leverage in the same rating buckets as its U.S. counterparts. In short, emerging-markets corporate bonds can be advantageous assets, but because of lower liquidity, it’s often better to hold them rather than frequently trading in and out of the asset class.
Frontier market bonds
Leaving emerging-market countries to travel to an even less developed region may be too much of a risk for some investors. But for those with a long-term mindset who are able to take on additional risk within their portfolios, there are the frontier markets.
Frontier markets have become an important part of the emerging markets story. They were once viewed by investors as one-dimensional, in that they were mostly driven by commodities. But that has evolved. Improving country fundamentals provided market access to many frontier countries, including the ones that are scarce in natural resources.
Today, much of the growth in frontier markets is influenced by what is known as the demographic dividend. The demographic dividend is a term for economic growth that results from declining mortality and fertility, and the resultant change in the age structure of a country’s population. The labor force in frontier markets has grown faster than the population dependent on it, and infrastructure investment has expanded. As these factors strengthened business activity, the market for bonds has gradually expanded.
Frontier-markets bonds represent only a fraction of the emerging-markets debt universe. As frontier markets continue to grow, opportunities continue to open up. Until then, those willing to buckle up for a long ride could be the first to broaden their horizons and take advantage of future opportunities.
How it all fits together: a blended approach to emerging-markets debt
You have figured out what you’re packing for your trip. Now for the real challenge: making sure it fits in your bag. Having a sense of how it all works together can help you through this process.
The same can be said for constructing a blended portfolio consisting of different segments of the emerging-markets debt universe. Not all emerging-markets debt is the same, and it is essential to know how each segment will react to various market conditions.
The primary drivers of returns for emerging-markets hard-currency sovereign debt are a country’s default rate and the levels of U.S. Treasury yields. A country’s probability of default is determined by a variety of factors, including economic growth, level of public debt and fiscal conditions. Emerging-markets corporate debt is subject to these drivers as well, and also considers the credit quality of the corporate issuer. And emerging-markets local currency debt is driven by currency valuations in addition to interest rates. So each segment’s performance is dependent upon different circumstances.
Each segment has strong merits as a standalone asset class. But a blended approach results in a portfolio that is diversified across a range of different countries, instruments and currencies. This can help the portfolio perform well in a variety of market environments, as each component will react differently as conditions change.
Each type of emerging-markets debt has different characteristics, which leads to differentiated sources of alpha.
Another advantage of using a blended approach applies to generating alpha, or excess return over a certain benchmark. Each type of emerging-markets debt has different characteristics, which leads to differentiated sources of alpha. For example, risk assets such as emerging-markets currency can provide investors with attractive return prospects when risk appetite increases, while high-grade hard currency corporate bonds can offer downside protection during more difficult periods in the market cycle. All of these types of emerging-markets debt have advantages during various points in the market cycle.
When constructing a blended portfolio, it is important to understand the various components and how they complement one another. Emerging-markets hard currency debt, emerging-markets local currency debt, emerging-markets corporate bonds and frontier-markets bonds are distinct asset classes that exhibit different credit quality and regional compositions while responding to different drivers of return. Each asset class has its own unique characteristics and advantages.
It is possible for some investors to make their own asset allocation decisions to achieve a blended portfolio. Another option is to hire a specialist fund manager to help find attractive return prospects within the asset class. Either way, making sure it all fits together when you first begin your journey will make for much smoother sailing as you continue on your adventure.
A change of plans
To paraphrase Robert Burns, “the best laid plans of mice and men often go awry.” This observation may come to mind for the world traveler dealing with delayed flights, lost baggage and road closures. It also describes the often unexpected political events we experienced around the globe in 2016.
In June, we had the UK’s referendum on whether or not to remain part of the European Union (EU). While consensus expectations and pundits predicted that the UK would vote to remain in the EU, it turned out that UK voters had other ideas. While the referendum was anything but a landslide for one side over the other, a majority of voters indicated they wanted to leave the EU (also known as “Brexit”), resulting in the resignation of former Prime Minister David Cameron and the election of Theresa May as his successor.
There are many uncertainties that still need to be worked through.
The Brexit vote sent markets reeling at first, as many believed that leaving the EU would cause an immediate recession in the UK. So far, though, this threat hasn’t materialized, although there are many uncertainties that still need to be worked through. Markets have stabilized, and bond yields have stayed near record lows as central banks in developed markets held rates steady to guard against the risk of a global economic downturn.
While the developed world continues to process what Brexit will mean from a trade and immigration standpoint, emerging markets don’t seem to be as concerned about the situation. As time has passed, investors have begun to view Brexit as a local problem rather than a global one. For this reason, many of them are looking at investments that stay as far away from any potential Brexit trouble as possible, and the developing world fits the bill.
Although governments and consumers in some emerging markets may be as strapped for cash as their developed market counterparts, many are not. And many of these countries still have leeway for some policy response from their respective central banks if the situation takes a turn for the worse. Considering the proliferation of zero and negative interest rates, this isn’t an option available to many central bankers in the developed world.
And then there’s the U.S. presidential election. While few predicted that Donald Trump would emerge victorious against his rival Hillary Clinton, this is exactly what happened. Similar to Brexit, the polls and commentators got it wrong, and many predicted that this outcome would immediately lead to Armageddon in the financial markets. And again, many of these initial predictions have been mistaken thus far, as equity markets have continued to rise on the hope that Trump’s policies will indeed spur growth in the U.S. economy.
But unlike Brexit, which is mainly centered on the relationship between the UK and the EU, U.S. policies under the Trump administration could have a direct impact on emerging markets, if Mr. Trump’s campaign rhetoric is to be taken seriously. Throughout the campaign, Mr. Trump called for bringing production back to the U.S. and renegotiating trade deals that he believes are hurting American workers. If tariffs are imposed, it would hurt profitability for companies in emerging markets such as China and Mexico.
If Trump follows through with some of the trade policies he has proposed, this is likely to be a negative for global trade, particularly for Asia and some of the countries in the broader emerging markets. However, there is also a greater probability of expansionary fiscal policy, which would allow for the possibility of a slightly higher path for global inflation. But for now, a greater degree of uncertainty exists, as the actual policies that will be delivered by a Trump presidency are difficult to predict.
There will always be uncertainties surrounding a new journey – whether related to travel or investments. In both cases, it is important to prepare for the unexpected as much as you possibly can. When traveling, it can mean keeping copies of your passport handy in case the original document is lost, or having a carry-on bag packed with essentials in case your checked bag doesn’t arrive at your destination. When investing, a diversified portfolio of global investments can help you prepare for the many changes that the financial markets often endure. A blended portfolio of emerging-market debt can help you with this effort.
Our travels through the world of emerging-markets debt have taken us through various regions of the globe and allowed us to explore the many opportunities that the asset class has to offer. But the journey doesn’t end there:
Over the past two years, over 100 million households have moved into the middle income range within emerging markets.3
The share of global retail sales attributed to emerging markets grew from 32% in 2000 to 51% in 2015.4
By 2020, a further one billion unique mobile subscribers will be added globally, with the vast majority of this growth coming from emerging economies.5
These trends are expected to continue as emerging markets expand and develop. With their favorable demographics and continued economic expansion, emerging markets are forecasted to become even larger contributors to the global economy in the years to come. According to PricewaterhouseCoopers, expectations are that China, India, Indonesia and Brazil will be four of the five largest economies in the world.6
Emerging markets are already major players in the global economy, and emerging-markets debt will continue to gain prominence as a global investment opportunity. Not only does this asset class offer relatively higher yields than comparable bonds in developed markets, but it also can provide a way to gain further diversification, which can help manage risk within a portfolio. For those who are traveling the world far and wide in the search for income, emerging-markets debt should prove to be a popular destination – one that offers a world of opportunity.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
The value of investments, and the income from them, can go down as well as up and you may get back less the amount invested.
1 Diversification does not ensure a profit or protect against a loss in a declining market.
2 Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
3 Credit Suisse. “Mega-Trend of Growing Emerging Middle Class Remains on Track.” January 4, 2016.
4 A.T. Kearney. “Emerging Market Retailing in 2030: Future Scenarios and the $5.5 Trillion Swing.” 2016.
5 Source: GSMA, February 2016.
6 PricewaterhouseCoopers,“The World in 2050,” February 2015.
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