For years now, many investors—ourselves included—have been advancing the notion that emerging-market debt (EMD) should not be viewed, or treated, as a single homogeneous trade.
The asset class has evolved significantly over the past 30-plus years and now is too diverse, with too many independent drivers of return, for a dogmatic and rigid approach. Domestic growth, inflation, credit risks, trade prospects, commodity demand—all of these factors and more affect the asset class in general and different segments of EMD will respond to these factors in markedly different ways. Today, the good news is that a meaningful population of investors has taken note of this diversity. The not-so-good news is that for many of those investors, their EMD allocation may not take full advantage of the opportunity sets available.
In the wake of the global financial crisis, many market watchers took note of the relative outperformance of EMD denominated in local currencies (rather than U.S. dollars, or USD). We can anecdotally report that since then no small number of investors, perhaps with an eye toward reducing risk, have pursued EMD with a portfolio tilt heavily biased toward local markets; the rise of 50% USD/50% local EMD mandates gives the appearance of giving in to this trend rather than true portfolio optimization. Although the local market universe can offer attractive opportunities, we believe a more tactical, opportunistic approach is warranted versus a strategically concentrated bet that excludes hard currency EMD exposures.
The local currency EMD market is large, but relatively uniform
To offer some perspective, it’s quite common for an emerging-market government to issue sovereign debt denominated in USD; doing so greatly expands the market of potential buyers and removes any unwanted local currency (and inflation) risks from the investment. While that’s still standard practice throughout the developing world, that’s not the only variety of sovereign EMD out there. So-called local market debt has grown considerably over the past 20 years and, by some measures, makes up more than half the total EMD market today.1 While large, the actual investable market represents a very narrow pool of assets: The primary benchmark tracking EMD local markets consists of just 20 countries, with the 10 largest issuers representing around 80% of the index.
Comparing the different segments of EMD
In comparison, the USD-denominated EMD sovereign/quasisovereign market is made up of 74 countries, while the USD-denominated corporate market consists of 59. It’s also worth noting that EMD local markets are almost entirely made up of sovereign bonds. Corporate EMD tends to exhibit different (if nuanced) patterns of risk and return than sovereign/government bonds in part because the segment is more diverse, including across sector, industry, and rating. In addition, the corporate market offers more direct exposure to key thematic investment opportunities, such as positive demographic trends among younger populations or an expanding middle class, rising commodity demand, or evolving consumer behavior and preferences. A heavy portfolio bias toward EMD local markets is by definition a bias toward sovereign debt, which may not always be the best approach to harnessing the growth potential in EMD.
Relatedly, the credit quality of the local universe, unsurprisingly, skews higher relative to the broader EMD universe, since only the more established, more stable countries are able to make a market for bonds issued in their local currency. We believe these relatively concentrated local market dynamics can undermine the motive for many EMD allocations in the first place: typically, excess return potential from a rapidly growing and diverse asset class. It’s important to highlight that although the main participants in EMD local markets are typically local institutional investors—banks, insurance companies, and pension funds, for example—the increased participation of nonresident (i.e., foreign) investors is growing and will be key for the further evolution of these markets.
Local currency markets are more volatile than investors may realize
One of the draws of EMD local markets has been its supposed resilience or diversification benefit in volatile markets; as we mentioned earlier, the segment did fare comparatively well during the 2008 sell-off. But taking a somewhat longer view paints a different picture. Since 2003 (the inception date for the primary local market index), local market debt has had a significantly larger maximum annual drawdown average (12.1%) relative to the USD sovereign (8.0%) and corporate (5.5%) markets. (By way of background, a drawdown measures an investment’s decline from peak to trough during a calendar year but doesn’t indicate whether the investment generated a positive or negative return during the year.) Regarding returns, local currency debt underperformed both hard currency sovereign and corporate debt during this timeframe.1
Hard currency EMD has offered higher returns and smaller drawdowns
Source: JPMorgan, Maulife Investment Management, as of September 30, 2021.
Using the same data series since 2010—in order to remove the impact of the global financial crisis—we see a similar drawdown story. But here, local currency debt significantly underperformed its hard currency counterparts, both of which generated more than twice the total return. It’s also worth noting that in the two calendar years when USD EMD had negative returns—2013 and 2018—local market debt underperformed.
The underlying reality here is that although many local bond (i.e., rates) markets performed well, the total return was often overwhelmed by negative currency returns relative to the USD. Our decades of experience investing in local markets has often taught us the same lesson: Despite strong structures and policies to support economic improvements that benefit local bond rates, the local currency return can often be overwhelmed by external forces such as a risk-off sentiment, G3 central bank actions, and the direction of the USD and U.S. interest rates.
Hard currency issues have offered better risk/return profiles
One of the most common means to investigate whether an investment is worth the inherent risks is to look at its Sharpe ratio—essentially, a measure of its unit of return per unit of volatility. Here, too, local currency debt has come up short. Using rolling 36-month observations since 2006, we see that USD sovereign debt and USD corporate debt have both had Sharpe ratios that hovered around 1.0 for the past decade, albeit with some significant fluctuation along the way. The Sharpe ratio for EMD local markets, on the other hand, trended decidedly down after the global financial crisis and since then has hovered around zero.2
Hard currency EMD has tended to offer higer risk-adjusted returns
Rolling three-year Sharpe ratio
Source: JPMorgan, eVestment, and Maulife Investment Management, as of September 30, 2021.
With all this said, it’s easy to ask whether it’s worth owning local currency debt at all—we believe it is. Targeted currency exposures can be one of the most effective diversification tools available, but it’s vital that the related risks be actively managed, just like any other. A passive, blanket exposure to EMD local markets—as we’ve seen—has produced relatively underwhelming results compared with the hard currency EMD market.
We believe a mandate that invests throughout the full EMD universe—sovereign, corporate, and local markets—provides more opportunity, better diversification potential, and ultimately a higher likelihood of attractive total returns than a mandate confined to only one area. Each of these market segments has investment merits of its own that change over time. We believe the ability to actively combine these opportunities is what unlocks their full benefits and can therefore provide the greatest potential in an EMD allocation.
1 JPMorgan, as of September 30, 2021. 2 JPMorgan and eVestment, as of September 30, 2021.
USD sovereign EMD is represented by the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified Index, which tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities, capping exposure to countries with larger amounts of outstanding debt. USD corporate EMD is represented by the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broadly Diversified Index, which tracks U.S. dollar-denominated debt issued by emerging-market corporations. Local FX sovereign EMD is represented by the J.P. Morgan Government Bond Index Emerging Markets (GBI-EM) Global Diversified Index tracks the performance of local currency-denominated, fixed-rate government debt issued in emerging markets, capping exposure to countries with larger amounts of outstanding debt. It is not possible to invest directly in an index.