Emerging market investment grade debt for insurance companies

Returns in historical perspective

The last three years have been a tumultuous period for EM owing to a series of rare and disruptive events; however, with yields currently at historical highs, recent history indicates that the asset class can deliver attractive risk-adjusted returns over the long term.

Following the last major global crisis, EM credit outperformed. From 2010 to 2019, EM investment grade (IG) debt produced higher returns than US IG debt, with only modestly more risk. We believe the asset class is poised to perform similarly well in comparison to US credit coming out of this recent period of crisis.

Like all risk assets in the wake of the global financial crisis (GFC), EM valuations, especially in credit, were depressed. Attractive valuations and relatively stronger fundamentals set the stage for attractive returns, which garnered the attention of investors and drove strong investment flows into the asset class. However, concerns among higher quality, long-term institutional investors about the relative newness, risk, and limited breadth of the asset class tempered those flows.

Evolution of EM debt stock

In our view, the questions of that period have been resolved. The asset class now has 25 years of sustained returns and growth, and over USD4 trillion of bond stock. More than half the market is now rated investment grade. The EM market is currently larger than the US high yield or commercial mortgage-backed securities markets and much more diverse.

Greatly improved credit quality across EM investment grade universe

Credit quality has also greatly improved across the sovereign and corporate segments of the EM investment grade universe, making it more suitable and attractive for insurers. In recent years, weaker credits fell out of IG to junk status, solid IG issuers sought more borrowing, the investable stock of bonds from solid IG issuers grew, and institutions across IG strengthened.

Over the last seven years, a heavy downgrade cycle pushed many riskier borrowers to high yield. Colombia lost its investment grade rating due to a mix of poor policies and some bad luck. The Mexican state-owned oil and gas company, Pemex, moved to high yield after years of posting credit metrics consistent with a single-B or lower rated credit. Most large, private Chinese real estate companies also fell to high yield, removing some of the more opaque and highly levered constituents of the corporate investment grade universe.

At the same time, the A and AA rating categories have expanded, driven by more borrowing from governments and companies in the Middle East, Asia and Latin America. Now, almost half of IG sovereign and quasi-sovereign names are rated A or better, with a similar story for corporates. So far in 2024, a larger percentage of the sovereign index has been upgraded than downgraded and rating agencies maintain more positive than negative outlooks on outstanding bonds. 

This ratings dynamic has corresponded with meaningful improvement in governance and institutional indicators, which we view as essential analytical counterparts to standard credit metrics like debt/GDP and fiscal balances. Political stability rankings among IG governments, as measured by the World Bank Worldwide Governance Indicators (WGI), are a good proxy for the qualitative improvement of these credits. The departure of weaker names and the strengthening of stronger names has boosted the overall institutional strength of the IG sub-index. At the same time, during COVID, the major EM central banks were largely more orthodox in approaching the crisis than their DM peers – hiking rates earlier, which has allowed them to cut earlier. In our view, these rankings and policy choices add texture to the raw numbers and provide a level of comfort that social and political stability can underpin durable economic and financial success.

The diversification benefits of a broad investment opportunity

Beyond the primary consideration of attractive risk-adjusted returns, EM debt also offers diversification benefits, with more than 130 countries and over 1,000 distinct issuers represented. In the past, a justifiable view held that EM hard currency debt was a narrow, highly correlated asset class. That is no longer the case and the safety provided by the dispersion of credits by region, country and individual issuer, especially in periods of stress, can be significant. For instance, we highlight the differences in economic fundamentals and market drivers of China, Peru, Qatar and Malaysia; they are different from each other and from the US. The EM market is broad in terms of credit quality and maturity profile, which reflects the strong growth in market size over the past decade of more than six times for corporates and three times for sovereigns.

Currency considerations – cross currency swaps

The EM credit asset class comprises a sizeable debt stock denominated in euros, though most of the market is denominated in US dollars. This can create some uncertainty for European institutions, whose base currency is euros or British pounds. Foreign exchange hedging in such situations has typically been done using currency forwards on a one- to six-month basis. While relatively simple to implement, such a strategy leaves longer-term investors subject to fluctuations in hedging costs.

Over the past three years, for example, hedging costs have fluctuated from 1.8% to 3.2% and back to 1.9%. Such movements can significantly impact returns and may be problematic for investors seeking certainty over the life of their portfolios. By adopting a slightly more complex hedging strategy that makes use of cross currency swaps, insurers may be better able to match hedges to the duration of their portfolios. We find this is a more efficient approach to managing foreign exchange risk than simple hedges using currency forwards.

Regulatory capital treatment

European insurance regulation is straightforward in its treatment of all fixed income assets, regardless of their origin. Under the Standard Formula of Solvency II, the capital charge is captured under the spread risk, as with other bonds. There is no specific treatment for EM debt.

If hedged into local currency, an EM bond consumes no more capital than a domestic bond with an equivalent rating.

For the bonds and loans of central banks and governments denominated in their own currencies, specific favorable shocks apply. Compared to corporate bonds, these shocks are more favorable.

EM debt that is completely swapped back into euros or sterling (using cross currency swaps) is eligible for a matching adjustment.

An attractive investment for insurers

EM investment grade debt is a large, diverse asset class that offers compelling value and will likely make up an increasingly large share of the global fixed income universe. As such, we believe an allocation to the asset class warrants serious consideration by insurers. At Invesco, we have extensive experience investing in EM debt and working with institutional clients to provide access to the asset class via tailored solutions that can meet their exact requirements.