The case for emerging-market debt
Bolstered by strong economic and demographic fundamentals, attractive risk/return profiles, and portfolio diversification benefits, we believe EMD should be considered a strategic allocation rather than a tactical one within most traditional investment frameworks.
- Constructive fundamentals. When compared with advanced economies, many emerging economies have lower debt-to-GDP ratios, and the GDP growth differential between the two markets continues to widen.
- Improving credit profiles. The secular decline in credit spreads is indicative of progress in structural reforms and the growth-oriented policy agendas of many governments in the EMD sovereign universe.
- Favorable demographic profiles. Relative to many of their advanced economy peers, EMs are benefiting from a burgeoning middle-class population and younger consumers.
- Attractive return potential. Historical evidence shows the potential for outperformance given a long-term investment horizon.
- Despite these attractive traits, investors in aggregate remain significantly underallocated to this asset class. We believe that’s a trend that deserves to be bucked.
A story that gets better with age: improving fundamentals
It’s a well-known fact that somehow continues to surprise: Many emerging economies have significantly lower debt-to-GDP ratios compared with advanced economies. In addition, many can also claim relatively lower levels of corporate and consumer debt. Interestingly, market commentators have recently been noting that advanced economies could represent a bigger risk to global growth than emerging economies—a distinct departure from the past.
One of the fundamental attractions of investing in emerging-market debt (EMD) is the ability to gain exposure to dynamic economic growth. In a world in which sluggish GDP growth has for years tested the limits of fiscal and monetary policies in many advanced economies, the growth differential offered by emerging economies is often all the more appealing.
According to United Nations data, emerging economies have represented more than 80% of the global population since 1995.1 Furthermore, they're also a significant component of the global economy, although not to the same scale—at least not yet. IMF data, released in January 2018, shows that emerging economies represent a significant and growing percentage of global GDP.2 It's clear that EM’s share of global GDP (in percentage terms) has roughly doubled since 1990—in nominal terms, it currently stands at around 40% (current prices in USD); in purchasing power parity terms (thereby equalizing purchasing power across currencies), the figure rises to around 60%, which highlights EM’s growing significance in the global economy.
Given expectations for a widening growth differential between advanced and emerging economies, this share should continue to grow. In our view, this truly begs the question as to why many global investors remain underweight in their portfolio allocation to EMD. Many institutional investors have been gradually increasing allocations to EMD in recent years as a way to help meet return objectives, but perhaps the more compelling argument for including EMD in a portfolio is because of the increasing significance these markets have in the global economy.
Young at heart: the positive demographics of emerging economies
It should come as no surprise that emerging economies are, on average, much younger than advanced economies. According to the United Nations, the median age of the total population in less-developed nations was just under 28 in 2015. That’s 10 years younger than the median age in the United States, and nearly 20 years younger than Japan.1
Many of these nations are also experiencing rapid urbanization as rural populations are enticed to move to big cities by the greater economic and social opportunities available. The resulting industrialization and infrastructure buildup, strong wage growth, and increased consumer spending that typically accompany this trend are helping to power economic growth. The rise in wages and disposable income, in turn, fuels consumption and drives the next stage of growth, creating a virtuous cycle in these markets.
The middle-class market in advanced economies has matured and is projected to grow at only 0.5% to 1.0% per year, while the middle-class market in emerging economies is far more dynamic and could register annual growth rates of 6% or more.
Source: “The unprecedented expansion of the global middle class,” Brookings Institute, February 2017.
Why do these demographic shifts matter? Apart from the expected trickle-down impact of what’s likely to be a considerable increase in spending in a host of consumer-related areas—including financial services, energy, and consumer goods—these shifts help emerging countries diversify their sources of economic growth away from external demand, which can often be more volatile.
By encouraging strong domestic demand, these developing nations can also expect to reduce their dependency on export demand. A stable domestic economy should, over time, lead to continued improving creditworthiness, and their domestic currencies would likely experience lower volatility. In addition, we expect the shift in consumer growth patterns to translate into a stronger and more diversified private sector. Companies in emerging economies will require access to long-term financing, which should, in turn, contribute to a broadening of corporate issuance.
Although allocating to the sovereign bonds of countries benefiting from the middle-class expansion can provide access to this important growth dynamic, we believe that a more effective way of gaining exposure is through corporate bonds. Combining sovereign and corporate allocations allows investors to focus on the real economy and identify relevant sectors that are experiencing major transformations. Specifically, we believe there are opportunities in areas that target end consumers, such as the consumer discretionary, telecommunications, utilities, and industrials sectors, that are part of a supply chain of goods for the growing middle class.
The credit profile in emerging markets has steadily improved
In the past, institutional investors viewed EMD with caution, as an asset class scarred by currency crises and debt defaults in Asia, Latin America, and Russia. However, as the asset class matured and the market deepened, the episodic volatility of past events increasingly seems to be just that—a thing of the past. As emerging economies have developed, fears of contagion have diminished. During the 2008 global financial crisis, volatility spiked, but even then—and throughout the past decade—EMD spreads versus U.S. Treasuries (which measure the incremental yield offered) have remained tighter than those of U.S. high-yield bonds versus Treasuries, reflecting investors’ perception of the level of risk entailed in EMD.
Case in point, the credit profile of many emerging economies has consistently improved since 1993. Today, over 50% of all EMD securities (both sovereign and corporate) are rated investment grade. That's a marked improvement from a quarter century ago, when less than 5% of the asset class could be considered investment grade.
The downward trend in EMD spreads and the improving credit profile in emerging economies are the result of two large-scale trends: first, the beneficial impact the strong commodity cycle has had on emerging economies, and second, the implementation of key government policy agendas by a number of major emerging countries. These government measures eventually created the relatively stable economic trajectories that are typical of many EMs today.
Additionally, the magnitude of the so-called EMD spread blowouts resulting from default events or other market crises with widespread contagion has steadily declined. We believe this dampening of volatility is the result of three interrelated developments:
1 EMD has become a larger and more diversified investment set that's increasingly being viewed as such. This reduces the likelihood of large risk-off trades as investors pull money out of the asset class en masse.
2 The asset class’s primary investor base has migrated away from hedge funds and proprietary trading desks to longer-term investors. This latter group includes traditional asset managers, global pension funds, insurance companies, and, over the last decade, sovereign wealth funds and other institutional investors.
3 Supply-and-demand dynamics have also improved. Policy reforms in areas such as securities regulation and investors’ rights have supported growth in investor appetite for both local and hard currency-denominated bonds.
In our view, the improvement in the credit profiles of emerging economies reflects a long-term structural story anchored in the relatively stronger growth dynamics of these economies. More recent downturns during the past few years reflect not a change to the overarching trends we’ve been describing, but the challenges faced by specific economies, some of which led to credit downgrades, notably in Brazil, Russia, and Turkey.
While these developments could be construed as unsettling, we take the view that short-term volatility can provide active managers with fertile ground for identifying opportunities. The bounce back in Brazil’s market performance after the impeachment of former President Dilma Rousseff and the steady returns in Russia (despite economic sanctions) are prime examples of how negative headlines can sometimes cloud the fundamental picture supporting a longer-term opportunity.
EMD has a secret weapon when it comes to returns: income
Of course, one of the primary attractions EMD offers is its higher return potential. While that potential for return has been accompanied by periods of volatility, we believe the asset class has displayed a resilience over the long term that makes it worthy of consideration for a wide range of investors with longer-term horizons.
When we look at the long-term performance of hard currency (i.e., U.S. dollar denominated) sovereign EMD compared with investors’ default risk asset—U.S. equities—some interesting patterns come to light. Over rolling one-year periods since 1994, the inception date for major EMD indexes, the average returns for both asset classes are similar, at around 11%. Both return figures fall slightly over rolling three-year periods, but still provide attractive returns of around 10%. But what’s strikingly different over a three-year time horizon is the downside profile for the two asset classes: The worst three-year return for U.S. equities was a 16% loss, while EMD posted a loss of only 1%. The frequency of losses is materially different also: Over the 252 rolling three-year periods, measured monthly, U.S. equities have posted losses 23% of the time versus only 1% of the time for EMD. This trend is just as material over longer time periods.
In our view, there are two key takeaways from this exercise:
1 The longer the holding period, the more likely a positive return for both asset classes.
2 The power of income has been a notable tailwind for EMD over even moderate holding periods.
In other words, the coupon income received by EMD investors not only provided downside protection, but also provided an incentive for investors to stay invested—particularly in periods of volatility. Combining the power of compounding with opportunities for price appreciation—attained through active security selection—creates what we believe is a very attractive potential total return profile, and one worth consideration by a range of investors with long-term horizons and allocations to risk assets.
We believe that a flexible approach—one that uses a dynamic allocation to hard currency sovereign and corporate debt as well as tactical allocations to local currency sovereign debt—offers the most value for investors. It’s also a good way of keeping pace with changes to the composition of EMs while pursuing the best opportunities the asset class has to offer.
How to get the most out of an EMD allocation
With decades of experience investing in EMD, we know that country selection is critical to alpha generation. However, as experienced investors know, it isn’t just about which countries to invest in, but also the strategy and approach taken in each country.
When it comes to investing in corporate bonds, we strongly believe that pursuing investment opportunities in the EMD space requires direct knowledge of the individual workings of a country and its real economy. Often, this insight can end up providing further support to—or in some cases, refuting—a prevailing top-down view.
In addition, corporate bonds can give managers the opportunity to express thematic or sector views, such as seeking to take advantage of a burgeoning middle class or capitalizing on growing domestic demand for commodities. Ultimately, that’s why we believe security selection is key to pursuing a particular investment theme within a positive sovereign outlook—a benefit that passive approaches aren’t designed to offer.
"Combining the power of compounding with opportunities for price appreciation—attained through active security selection—creates what we believe is a very attractive potential total return profile ..."
And when it comes to tactical allocations to local currency-denominated debt, we believe it’s important to acknowledge that external forces—including the relative strength of the U.S. dollar and G3 central bank policies—can overwhelm whatever investment opportunities exist in local currency debt markets. Although many countries have taken steps to minimize the influence of these external forces (such as adopting a floating exchange rate or increasing the size of their foreign reserves), our experience suggests that the currency market continues to serve as the primary transmission mechanism to express risk-on/risk-off sentiment for emerging markets.
Although in our own fund, we maintain small, tactical positions today given these market dynamics, we look forward to further maturation of the local currency debt markets and a future in which real yield opportunities in local markets can be held strategically.
Conclusion: stay active and do your homework
Ultimately, the phrase emerging markets has come to embody a diverse group of economies, each with its own growth trajectory and unique set of challenges. It's far from a homogenous asset class, and for that reason we believe that a flexible investment approach is necessary to pursue attractive returns. In our view, the scale, breadth, and diversity of the EM universe remain compelling, especially from a long-term perspective. While there will always be potential for negative headlines in the short term, it doesn't negate the asset class’s potential to yield strong returns over the longer term, especially on a risk-adjusted basis.
For investors, we believe a shift in perspective is required. In our opinion, the traditional view of limiting EMD to a tactical allocation should be challenged. The narrative for emerging economies has changed, and the market—along with the underlying economies—has become more sophisticated. It's time, we believe, to view the asset class in another light and for investors with risk allocations in their portfolios to consider making use of the benefits EMD has to offer.
1 “World Population Prospects 2017,” esa.un.org, as of July 2017. 2 “World Economic Outlook,” imf.org, as of January 2018.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions.