It was a “too-good-to-be-true” moment for many when the Federal Reserve cut interest rates by 50 basis points on September 18, 2024. Though the cut was anticipated, it was larger than expected.
Analysts are now expecting another 25 basis points cut before the end of the year, according to Reuters. Some policymakers also predict that interest rate cuts will persist until at least 2026.
One question has arisen for asset owners since the September cut: is it time to allocate more funds towards emerging market debt?
This may be a tempting thought, but if we have learnt anything from the 1982 emerging market debt (EMD) crisis, it is that interest rates cannot be the sole consideration when evaluating emerging market debt.
To answer this dilemma, this article will consider the current state of emerging market debt, the opportunities presented by this market, and the risk factors that asset owners must be conscious of when allocating funds towards EMD.
Contents list:
- The current state of emerging market debt
- Key factors that make emerging market debt desirable
- Emerging market debt risk factors: Top reasons for caution
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1. The current state of emerging market debt
A quick review – what is emerging market debt?
Simply put, EMD refers to debt (or fixed-income) securities issued by developing economies. They can be sovereign debt issued by the government, municipal debt issued by government agencies, or corporate debt issued by corporations.
Emerging market countries include the BRICS countries (Brazil, Russia, India, China, South Africa) and other developing economies in Latin America, Sub-Saharan Africa, Europe, the Middle East and North Africa (MENA).
Emerging market debt can be issued in local currencies (the country’s currency) or hard currencies (the currencies of developed economies – dollars, pounds, and Euros, for example).
Many market indices track the performance of various EMD securities, with the Emerging Market Bond Index (EMBI) issued by J.P. Morgan being the most popular. The three variants of EMBI include:
- EMBI+: This measures the performance of traded debt securities in emerging markets.
- EMBI Global Index: This is the expanded version of EMBI+. It includes USD-denominated Brady Bonds, Eurobonds, and loans.
- EMBI Global Diversified Index: This index assigns smaller weights to countries with higher debt stocks.
Many emerging market debt funds have also been created, with the iShares J.P. Morgan USD Emerging Markets Bond ETF the biggest by assets under management. These funds use J.P. Morgan’s Emerging Market Bond Index as their benchmark.
Institutional investors from developed economies are interested in emerging market debt for two key reasons: a search for higher returns and a need for a diversified portfolio.
“Emerging market debt offers potentially higher returns due to the greater level of risk associated with investing in rapidly growing and sometimes politically unstable countries,” according to SEI, a technology and financial company. “Moreover, its performance is not typically tied to other traditional asset classes, so investing in it may help to diversify portfolios.”
With that introduction out of the way, let’s consider the current state of emerging market debt.
The size of emerging market debt
There are 900 issuers of emerging market debt across 90 countries with a market capitalisation of $4.5 trillion, according to Marcelo Assalin, the head of the Emerging Markets Debt Team at investment management company William Blair.
If we look only at corporate bonds, the market capitalisation is $2.5 trillion, according to Jonathan Davis, a portfolio manager at PineBridge Investments focusing on emerging market fixed income. At the end of 2023, Bank of America valued emerging markets sovereign bonds at $1.5 trillion, according to a report by UBS, a global financial firm.
Performance of emerging market debt in 2024
A total of $321 billion in emerging market debt was issued in H1, 2024. This was the busiest first half of the year since 2021, according to Bloomberg.
Similarly, emerging market dollar debt issuance (excluding China) between January and May 2024, exceeded $200 billion, according to data from Fitch Ratings, a credit ratings company.
What about the performance of emerging market debt? The following highlights give us a clear idea:
- For H1, 2024, hard-currency emerging market debt had a 2.34% return, local-currency emerging market debt had a -3.71% return, and corporate emerging market debt returned 3.85%, according to data provided by State Street Global Advisors.
- The performance of emerging market debt has been improving over the past three months (June to August), as data provided by Abrdn Investments shows.
Emerging market debt funds have also been performing well.
As of September 23, 2024, the 19 emerging market debt funds tracked by ETF Database had a mean yield to date (YTD) of 6.82% with total returns ranging from 2.84% to 11.54%. This is greater than the yield on U.S. Treasuries and the mean YTD of US corporate bonds ETFs.
(Note: Past performance is no guarantee of future results.)
Changing dynamics of emerging market debt
One interesting dynamic is the rising participation of Gulf Cooperation Council (GCC) countries in the emerging market debt market.
Between January and May, GCC countries issued 51% of all dollar-denominated emerging market debt, up from 43.7% in 2023 and 32.8% in 2022, according to data from Fitch Ratings. Saudi Arabia and UAE have especially been big drivers of this trend.
2. Key factors that make emerging market debt desirable
We have seen that the lower interest rates in the US have led to new discussions about allocating funds to emerging market debt. However, interest rates are not the only factor to consider, as the 1982 emerging market debt crisis taught us.
In this section, we consider more fundamental factors that make emerging market debt desirable.
According to Jonathon Davis, the expert cited above, there are four key factors:
1. Less severe inflation
Emerging markets spent less on stimulus packages during the COVID-19 pandemic. Consequently, inflation has been less severe among them. Emerging markets were also quicker to raise interest rates to bring inflation down.
“Free of substantially above-trend inflation, emerging market economies have been less affected by high policy rates, and EM consumers have seen less of an impact on their purchasing power,” said Davis.
2. Higher economic growth
Emerging markets, having raised rates early to control inflation, are now cutting rates or are well-positioned to do so, according to State Street Global Advisors.
One consequence of this is that emerging markets are expected to grow faster than developed markets in 2024 and 2025. “Lower inflation and a more benign monetary policy response continue to benefit emerging market economies, which have higher growth outlooks than in the US and Europe,” said Davis.
3. Strong credit fundamentals among corporate debt issuers
Many asset owners often focus on sovereign debt when considering emerging market debt. However, corporate emerging market debt is also a substantial and well-performing market.
The positive outlook on sovereign debt has also contributed to favourable ratings for corporate debt.
“While the global economic outlook is less certain, the acceleration of emerging market growth is driven in large part by strength in domestic economies, which benefits many sectors of the corporate bond market – consumer, financial, and utilities, for example,” said Davis.
This is especially seen in the sound credit fundamentals of emerging markets corporates. “Leverage levels remain low and interest coverage is healthy,” according to Abrdn Investments.
Davis agrees: “EM corporate issuers tend to have greater financial flexibility than developed market corporates as a whole, with leverage ratios substantially lower than those of similarly rated DM peers.”
4. Subdued reactions to elections
Political volatility has been one of the headwinds that have affected investment in emerging economies.
However, elections in many developed economies in 2024 have not resulted in any political turmoil even in countries where the incumbent government was voted out (as in India and South Africa).
“The market reaction (to elections) has been relatively subdued, even when the results were not ‘market-friendly,’” said Davis.
In other words, even when parties that are not market-friendly have won elections, there have not been significant negative outcomes in the financial markets.
3. Emerging market debt risk factors: Top reasons for caution
Everything sounds good so far. However, asset owners must also understand certain risk factors that remain with emerging market debt (despite the positive outlook above) and include them in their emerging market debt strategies.
We identify four of these risk factors below:
1. Divergence
So far we have treated emerging markets as a single asset class.
However, a positive emerging market outlook does not mean that all emerging markets have a positive outlook. In most cases, there is a divergence – while the market as a whole is doing well, some countries are lagging.
Note that while the emerging market CPI inflation is a little less than 4%, countries like South Africa, Mexico, and Brazil have inflation rates above 6%. Similarly, while the average policy rate is just a little above 4%, Mexico and Brazil have policy rates above 10%.
The growth forecasts from PineBridge Investments above provide another illustration. Note that while the global emerging market is expected to grow by 3.87% and 3.97% in 2024 and 2025, respectively, subsets like Asia have higher growth forecasts while some like Latin America have lower growth forecasts.
If we consider country-level growth forecasts, the divergence becomes even more obvious. For example, in the July 2024 IMF growth forecast, projected growth for South Africa is only 0.9% while that of India is 7%.
2. Idiosyncratic risk
The divergence among emerging markets implies that there is an idiosyncratic (country-specific) risk unique to each economy.
Jonathan Davis emphasised this point when he talked about corporate bonds in emerging markets. “While credit fundamentals are strong across EM corporates, careful issuer selection takes on even greater importance in an environment of tight financial conditions and macroeconomic uncertainty.”
That is, looking at the average leverage ratios of emerging markets is not enough. Asset owners must consider the unique credit fundamentals of corporations in each emerging market economy.
State Street Global Advisors make the same point: “As individual countries pursue their domestic policies there is no guarantee that those policies align with what investors consider orthodox.”
They mention the unconventional monetary policy of Turkey and how it has impacted currency and market risk, China’s property market woes, and Russia’s delisting from some indices following its invasion of Ukraine.
Debt sustainability is another important idiosyncratic risk to consider. During the 1982 crisis, we saw how Latin American countries struggled to repay their debt due to economic volatility.
This is one area where asset owners should look beyond averages. Though the debt-to-GDP rate of emerging markets is lower than that of developed markets, some emerging markets like China have a higher-than-average ratio while some like India have a lower-than-average ratio.
Interest payment as a percentage of revenue is a reliable measure of a country’s debt sustainability and ability to avoid a sovereign debt crisis.
Other idiosyncratic risks include liquidity risk (the difficulty of repatriating capital), interest rate risk (higher interest rate leads to lower bond prices), sustainability risk (whether corporates are ESG compliant), and inflation risk (inflation rate exceeding returns).
Because of divergence and idiosyncratic risk, asset owners and individual investors who buy emerging markets debt funds must scrutinise their prospectus and key information document (KID) to understand asset allocation and what it means for the fund’s risk profile.
3. Contagion
The 1981-1982 Latin American crisis and the Asian financial crisis of 1997-1998 have shown that investors tend to treat emerging markets as a single whole and a crisis in one country can quickly spread to others (what economists call contagion).
In emerging markets, a falling tide can sink all ships just in the same way a rising tide can lift all boats.
Contagion can result when countries are exposed to the same risk factors (currency and commodity prices, for example) and sometimes they are not backed by any fundamentals (reducing the benefit of diversification).
“Emerging markets are also susceptible to swings in investor confidence and broad risk appetites even though a sharp change in sentiment may have no bearing on an individual country’s economic fundamentals,” said State Street Global Advisors.
Consequently, asset owners must be aware of the impact of contagion when allocating funds to emerging markets. They should focus on countries with strong fundamentals while also paying attention to general (broad) risk appetite and implementing sound risk management strategies.
4. Currency risk
Exchange rate fluctuation is one of the most significant risk factors for local-currency emerging market debt.
Local currency depreciation can erode returns on a local-currency emerging market debt. If the return is not high enough, currency depreciation can even reduce the value of investments, turning a positive return (in local currency) into a negative one (in a hard currency like the U.S. dollar).
This is why State Street Global Advisors advise that asset owners should conduct a currency valuation and only invest in local-currency emerging market debt when the local currency is undervalued and avoid it when the currency is overvalued.
US elections
The US remains the biggest economy in the world. Also, the 2008/2009 financial and economic crisis has shown that when the US sneezes, others catch a cold.
Thus, the results of the November 2024 Presidential Election (and other elections) can have significant impacts on the desirability of emerging market debt.
As Davis puts it: “The US election remains a potential risk event that is already creating unpredictability that will likely persist through November.”
He emphasises how the election can impact US trade policy and the resulting impact on emerging markets. But he is not the only one who thinks this is important. “Trade policy will again be front and centre of the US election campaign,” said David Rees, a Senior Emerging Markets Economist at Schroders, an asset management company in the United Kingdom.
After analysing the correlation between US and emerging market GDP growth in the past, Rees shows how the outcome of the election will result in varying levels of growth for emerging economies.
Mastering emerging market debt investing: The power of communities
It should be obvious by now that emerging market debt investment goes beyond keeping an eye on US interest rates.
As an asset owner interested in emerging markets, you must understand the dynamics of the market – growth, inflation, credit fundamentals, divergence, idiosyncratic risk, contagion, currency risk, among others – before making investment decisions.
But this does not have to be a burdensome task that you need to do alone.
At cio investment club, we provide you with a community of investment professionals, experts, and decision-makers where you can share investment advice, knowledge, and insights on various investment topics, including emerging markets.
We also organise exclusive roundtables and investment breakfasts where you can have face-to-face contact with asset managers and other asset owners and keep updated on the latest industry trends and best practices.
[Want to be a part of the cio conversation? Register today to gain access to a growing network of investment professionals and exclusive roundtable events]
Takeaways
- The cut in US interest rates is leading to increased conversations about investing in emerging market (EM) debt.
- Given the emerging markets crises in the 1980s and 1990s, asset owners must look beyond interest rates when considering investing in these markets.
- Lower inflation, higher growth prospects, corporates’ strong credit fundamentals, and less political turmoil following elections are some factors that make emerging market debt sound investment opportunities.
- Asset owners must also consider risk factors like divergence, idiosyncratic risk, contagion, currency risk, and the coming US election.
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