Why consider investing in emerging market local debt?

Emerging market local debt opportunities: Why now?

We believe emerging market (EM) local debt is set to outperform over the next several years after the asset class suffered one of the largest selloffs since the 1990s in 2022.

Last year, global financial markets and economies suffered a series of shocks. The war in Ukraine, pandemic-related supply shortages and slowing growth in China after Covid-19 lockdowns, exacerbated inflationary pressures around the world.

Volatility hit EM local debt markets as central banks like the US Federal Reserve raised interest rates and tightened monetary policy aggressively.

Now these negative shocks seem to be abating and evolving global macro conditions are expected to favour EM countries. We believe global interest rates are set to stabilise and monetary policy will focus on fighting inflation. In the meantime, China has started to reopen its economy.

Nevertheless, some uncertainties remain. Overtightening by global central banks may cause sluggish global growth, the exact speed of China’s reopening remains uncertain and geopolitical risks linger.

But with inflation peaking, we think EM yields in real terms are at especially attractive levels. EM local bond yields have been at a level not seen in more than a decade. Currently EM local bonds yield around 7% on average, around 400 basis points more than the US 10-year Treasury. For investors with a long-term perspective, at this point we believe now could be a potentially attractive entry point for EM local debt. 

What is emerging market local debt?

Back to basics: a brief definition

Emerging market debt is the fixed income debt that is issued by countries with developing economies as well as by corporations within those nations. It includes local and hard currency.

Local currency bonds are debt securities issued by sovereigns or corporates in their local currency. The return drivers come from local yields, capital appreciation (changes in yield curve or credit standing) and forex (FX).

Since countries can be at different stages in the economic cycle, interest rates and returns can be uncorrelated to those in developed markets. Given continued growth, local currency bonds tend to be more liquid than hard currency bonds and the list of markets with investible/liquid local bond markets that are accessible to foreign investors continues to increase.

Hard currency bonds are debt securities issued by sovereigns or corporates in other currencies – usually in a developed market currency, such as the US dollar or euro. Many low income, weaker developing countries, “frontier markets,” are incented to issue in hard currency to attract foreign investment. This is perceived as less risky if issued as a US or euro asset versus issuing in their local currency. 

How can investors benefit?

EM local debt can offer investors access to the attractive growth dynamics typically associated with the emerging market asset class as well as potential benefits from local currencies appreciating in value. It could potentially offer significant yield enhancement to fixed income investors willing to raise their risk tolerance somewhat, and offers equity investors risk mitigation potential for a modest sacrifice of returns.
 

EM debt’s role in a client’s overall portfolio

As seen in Figure 4, EM local debt offers greater opportunity for diversification compared to US dollar-denominated emerging market debt and US high yield — two typical choices for yield pick‑up versus traditional US core fixed income. With low correlation to both US stocks and bonds, exposure to EM local debt can potentially improve portfolio diversification for both equity and fixed income investors. 

What are the main investment risks?

The main risk to emerging markets has roots in Stephen Jen’s, co-founder of Eurizon SLJ Asset Management, Dollar Smile Theory. This theory suggests the US dollar strengthens when the economy is either very strong or also extremely weak.

US dollar strength that’s tied to run away, unanchored global inflation and/or a deep protracted recession are risks to the outlook for the asset class. Untenable inflation would force central banks to continue rate tightening putting pressure on absolute local rates (and FX by definition), while further restricting financial conditions and ultimately growth. 

Similarly, a sustained global recession and “flight to safety” by investors would lead to US dollar strength that’s disruptive for local currencies.

Default is also a risk. If a company’s financial profile deteriorates it may not be able to pay back creditors and potentially default. Issuer credit ratings provide a general guide of financial health, though this needs to be assessed on a case-by-case basis. 
 

Incorporating ESG

We believe that the integration of ESG into sovereign investing needs to incorporate an assessment of a government’s policy intentions.  This bridges the gap between specific investment projects and behaviour that promotes ESG goals at a macro level for a specific country.

Our approach focuses on considering sovereigns along with their sustainability momentum and potential, favouring those countries where momentum is strong and/or potential is high, and disliking investments where momentum is weak (or negative) and/or potential is low.

ESG factors play an important part in assessing macroeconomic contexts in sovereign investing as they are long-term drivers for the global economy. Our research is also informed by Invesco’s fixed income framework on sovereign debt rating.

This gathers relevant information in a proprietary scoring tool to generate a composite ESG profile for each country, so that relative performance and directionality of change across developed and emerging markets can be compared.

We make efforts to integrate ESG factors at all steps of the investment process and portfolio construction. Our top-down global macro analysis aggregates individual country views into a global economic baseline and helps us determine the portfolio’s overall risk profile.

Our global macro view also emphasises a country’s growth level and direction of change towards sustainability, such as incorporating sustainable energy, health care access and food security that are crucial factors for stable long-term economic growth.

The identification and analysis of aggregate macroeconomic ESG themes allow us to identify and better monitor risks at the overall portfolio level.

We believe countries with good government quality and a strong pro-investment policy mindset are inherently beneficial to long-term sustainability. This has an enduring positive environmental and social impact on the wellbeing of these country’s citizens.

How will US policy and rates influence EM debt going forward

EM local debt, like most asset classes, remains sensitive to US policy rate development. Increased clarity on the Fed’s forward rate path and the resulting terminal rate is necessary.  

We believe that a reduction in US rate volatility, as opposed to the absolute level of interest rates, is critical for sustained performance in emerging markets and could act as the inflection point needed to catalyse developing markets.

The investment opportunity in EM local currency is significant in the medium to long term. Though there could be setbacks over the next few months, the value created from an absolute income and return perspective is meaningful, in our view.

We believe the current environment of widespread idiosyncratic country news stories and elevated return dispersion provides a fertile landscape to extract performance alpha in the asset class once clarity on the Fed’s monetary policy trajectory become more visible over the next 6 to 9 months.

A year ago, EM monetary policy rates averaged around 3.25%. Fast forward to today and the average policy rate is over 6.75%, though there is divergence across regions.  Additionally, EM local markets have priced in more rate hikes and most EM sovereign yield curves have flattened.

Idiosyncratic country stories are starting to drive market direction instead of Fed policy action or the course of the US dollar. With inflation starting to moderate in some developing regions we see positive signals developing in the asset class.
 

How will the US dollar impact emerging market debt

EM local debt returns are partly dependent on the performance of the US dollar and tend to be higher when the US dollar is stable or weaker. We anticipate that, as rates markets stabilise, high US twin deficits will likely weigh on the US dollar going forward.

EM currencies are often perceived as a volatility driver. Yet the high carry (when investors borrow in a low-yielding currency to fund investments in higher yielding assets) available on EM local debt has historically compensated for EM currency volatility.

Combined with the drawdown of 2015, and without significant recovery in between, this long period of negative performance has led to a high valuation of the US dollar and historically low valuations for EM currencies.

On a real effective exchange rate basis (REER), EM currencies overall are close to their lowest valuations since 2004, while the US dollar is near its highest valuation. This is despite the introduction of China into the index, with a weight of around 10% and a stronger currency than those it replaced, in particular, Russia (prior to the invasion of Ukraine).

It’s likely the performance of EM as an asset class will depend on conditions that can lead to a weaker US dollar and stronger EM FX.

The US bond market is currently pricing in a rapid Fed tightening cycle, followed by a mini-easing cycle in 2023 on expectations that inflation will decline sharply. We believe this scenario could have two impacts: the EM-US interest rate differential should start to stabilise and perhaps move against the US, and recession fears should abate. Neither would bode well for the US dollar in the medium or long term, in our view.