8 minSummary of emerging market debt
Jean Philippe Donge When managing a diversified bond portfolio, the investment generates performance on at least two levels: the first via periodic interest payments, and the second via price appreciation (before redemption or resale on the market). In the case of a bond, price appreciation occurs when interest rates fall, or when the bond approaches maturity if the purchase price is below par. It should be noted that a third variable can contribute to the total return of a bond investment. This is the evolution of the bond's currency when it is issued in a currency other than the investor's reference currency. A favorable or unfavorable trend in the exchange rate against the portfolio's (or investor's) reference currency therefore also influences the performance of the bond investment.
In our previous writings, we have regularly returned to the principle of decorrelation in the bond portfolio construction process. In this process, when the manager is aiming for optimal diversification, the challenge is to achieve an allocation that enables the full potential of issuers and categories1 of issuers with a positive performance to be exploited, in particular with a view to making up for underperformance elsewhere. When we take these different aspects into account, we understand that investing in emerging market bonds can help us achieve such an objective.
Therefore, for the reasons we will further outline below, which are both technical and fundamental, investors cannot ignore emerging market debt as a truly optimizing element in their portfolio construction.
1981 vs. 2024: inflation, the surprise guest
Until recently, we had to contend with extremely low or even zero interest rates for sovereign debt in developed countries, and even for some private issuers. In such conditions, bond portfolios could only hold up thanks to interest income (however low), coupled with steadily falling yields in a disinflationary environment. In 2021, inflation made a comeback, particularly in the Eurozone and the United States. After fluctuating around 2% or even 1% over the previous decade, the US consumer price index rose sharply, peaking at 9.1% in June 2022 (see article on “Bond management and rising interest rates”). The last time these levels were seen was in 1981. The return of post-Covid inflation has therefore brought to a halt the downward trend in bond yields that began in 1981 (when the US 10-year yield was close to 16%). This recent upturn might have raised hopes of a new environment in favor of bond investments, with issues offering high coupons. However, as supply chains were re-established and interest rates were raised by central banks, inflation finally gave way again. This has halted the rise in interest rates, at least for the time being. In the eurozone, the ECB has begun a new cycle of rate cuts, while Germany has announced its entry into recession.
Fundamentals and markets
In view of these market considerations, it is important to take into account the evolution of fundamentals (governance and solvency criteria, in particular). At this level, it is important to understand that the formerly industrialized countries (or Western countries) have recently seen their debt levels deteriorate as a result of massive fiscal spending and “exceptionally accommodating” monetary policies. This has ultimately weighed on the attractiveness and credibility of their currencies and, more generally, on their creditworthiness as borrowers. In this respect, the case of France's budgetary slippage is particularly telling. Meanwhile, in a number of emerging countries, we have witnessed greater fiscal rigor and monetary orthodoxy in many cases, against a backdrop of an emerging middle class, growing industrialization and increased regional integration.
Illustration: the private sector as the embodiment of the emergence of the “countries of the South”.
The private sector is a crucial lever for development in emerging countries, contributing to job creation, economic diversification and innovation. Companies such as FEMSA (Mexico), Tencent (China), Embraer (Brazil) and SABIC (Saudi Arabia) are good examples of this dynamic.
FEMSA, with sales of $27 billion and over 300,000 employees, demonstrates how a favorable business environment can encourage growth. In Brazil, Embraer generates over $5 billion in annual revenues and employs over 18,000 people, benefiting from regulatory reforms that facilitate technological innovation.
In its Business Ready 2024 report, the World Bank highlights the improvement in business conditions in countries such as Mexico, Vietnam and Indonesia, with reforms that simplify access to financial services and improve public infrastructure. This progress enables local companies to compete internationally, while supporting national economic growth.
This state of affairs is reflected in the financial markets. Over the years, emerging market debt has established itself as an asset class in its own right, attracting investors keen to diversify their portfolios while benefiting from higher yields. Over time, and with lower volatility, the asset class has outperformed historically, and its performance potential remains intact.
Recent developments
The performance of emerging markets has been both dynamic and transformative over recent decades. As developing countries continue to account for a growing share of the global economy, investing in their debt instruments has become a strategy for capturing this growth. Emerging market debt encompasses bonds issued by the governments and corporations of these economies, offering higher yields than their developed market counterparts. In fact, the market for dollar-denominated corporate debt issued by emerging countries has almost doubled in the space of a decade, reaching almost $2.5 trillion in 2024. This growth is driven in particular by increasing demand for high-yield debt. Today, at sovereign level alone, the average yield on emerging country bonds is around 7.7% in dollar terms, compared with just 4.2% for US Treasuries.
In conclusion: a risky yet resilient asset class, essential for a diversified bond portfolio
Emerging market debt offers opportunities for high returns, but is also associated with specific risks. These include political and economic instability, currency volatility and liquidity risks. Emerging markets are often more sensitive to political upheavals, as evidenced by the debt crises in Argentina and Sri Lanka. In addition, the exchange-rate fluctuations we mentioned earlier can erode gains, especially for bonds denominated in local currencies. Periods of depreciation, such as those seen between 2014 and 2016, have highlighted the challenges that such investments can pose. However, despite these challenges, which can help to fuel a number of misconceptions, emerging markets have shown remarkable resilience in the face of recent economic shocks. In a report published last June, the Bank for International Settlements highlighted the improvement in this resilience thanks to structural reforms and the increased credibility of central banks. For instance, in contrast to previous cycles, central banks in emerging markets were able to anticipate the surge in post-COVID inflation, thereby reinforcing economic stability in these regions. The introduction of inflation-targeting policies and more flexible exchange rate regimes prior to the pandemic helped stabilize investor expectations and reduce the risk of volatility. In addition, emerging markets now account for over 50% of global GDP, and by 2030, 60% of global middle-class spending is expected to come from these regions. The expansion of this middle class, coupled with the advent of fast-growing business sectors, is of great interest to investors. Indeed, as part of a diversified bond portfolio strategy, the inclusion of emerging market debt can capture superior performance potential while improving portfolio resilience to global macroeconomic fluctuations. Thus, including these assets in a portfolio is no longer simply an option, but a necessity for investors wishing to optimize their long-term performance.
1 "Categories" should be understood here in the broadest sense (regional, sectoral, issues in currencies other than the issuer's reference currency, etc.).
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Date of publication: 31 October 2024
Time of publication: 10:30
Author:
Jean-Philippe Donge, Head of Fixed Income, info@bli.lu
The author of this document is employed by BLI - Banque de Luxembourg Investments, a management company approved by the Commission de Surveillance du Secteur Financier (CCSF) in Luxembourg.
