Well-chosen emerging market bonds on track for good returns
• Demand for debt from developing world hits record volumes, but investors need to be picky
The first half of 2017 has been marked by gluttonous demand for emerging market bonds, with record year-to-date volumes traded, and still counting.
Investors’ demand for emerging market debt has been spurred by a continued search for credit-yield enhancement in an environment of persistently low to negative global interest rates as the recovery from the global financial crisis plods on.
Amid the flurry of investor activity, it’s important to remember that emerging market debt is not the monolithic asset class it was once thought to be. We lean on top-down economic analysis and a quantitative approach to identify pockets of value within this sovereign debt market.
It’s important to bear in mind the distinction between a country’s local and foreign currency denominated debt and the risks associated with each.
To understand this distinction we need to wind back to 1989. Emerging market debt became a truly tradable asset class with the introduction of Brady Bonds, named after then US treasury secretary Nicholas Brady. These foreign currency denominated bonds, primarily issued by Latin American markets, were introduced in an effort to restructure the distressed debt of these nations and, over time, facilitate greater secondary market tradability of emerging market debt.
Although providing the benefit of access to global financial markets at the time, the issuance of foreign currency debt burdened these sovereigns with foreign currency risk in an environment where the issuers had no control over money supply.
Today, given the benefit of well-integrated and globalised financial markets, the expansion of emerging market debt as an asset class has allowed these sovereigns to largely escape the original sin of debt, where a sovereign issues debt in a currency not its own.
Local currency debt issuance allows for the transfer of currency risk from a sovereign issuer to a foreign investor, and generally allows governments to issue bonds at favourable pricing relative to foreign currency denominated issuance.
The development of the emerging market bond universe, coupled with the rapid economic growth of the developing world relative to that of the developed world in the past decade, has resulted in the transformation of emerging market debt as a niche asset class in the Brady era to a $12trillion behemoth, with market expectations of a tripling of outstanding debt over the next five years – predictably dominated by local currency issuance. The estimated 35% of emerging market bonds relative to total global bond issuance pales in comparison with the near 60% contribution to global economic growth of these markets.
The medium-term forecast for a continual growth divide between developing and developed markets will allow scope for the continued growth of the emerging market debt universe.
This improved economic backdrop is not only evidenced by favourable growth dynamics for emerging markets, but by improved external vulnerability metrics for the broader emerging market universe as well.
We need look no further than the so-called Fragile Five nations of Brazil, Indonesia, SA, Turkey and India, so termed in 2013 as a result of their burgeoning twin deficits (cumulative current account and fiscal account balances) and related macroeconomic vulnerability. A confluence of often painful currency devaluation, fiscal discipline and growth-enhancing policy reform since then has long since made the Fragile Five moniker irrelevant.
On a forward-looking basis, we believe the US economy is well primed for a continuation of the Federal Reserve’s steady and well telegraphed interest rate hiking cycle, which global financial markets will take in their stride. Meanwhile, China’s serially deteriorating growth trajectory, exacerbated by skyrocketing external debt remains a major source of systemic emerging market risk.
In a fixed-income context, emerging market debt offers attractive yield enhancement and a measure of diversification against rising developed market interest rates – primarily for foreign currency denominated debt which is immune to currency hedging costs.
However, an investment approach combining strict selectivity based on fundamental macroeconomic research and underpinned by a deep qualitative understanding of emerging market dynamics is required to harness the best value from this dynamic and fast-evolving asset class.