Emerging market debt offers the potential for attractive returns and enhanced diversification for international investors. The asset class spans more than 80 countries.

It includes bonds in US dollars and local currency, from governments and corporates, across a wide range of issuers of varying credit quality. How should investors approach this diverse investment universe?

All four pillars of emerging market debt – US dollar sovereign bonds, corporate bonds, frontier bonds and local currency sovereign bonds – offer a higher yield than government bonds in developed markets.

However, these returns are not risk free. Investors must be able to analyse debt sustainability across this diverse universe. Diversification is not guaranteed either. Yields are sensitive to global risk appetite, which drives flows into and out of the asset class.

Investors need to understand the monetary policy frameworks, exchange rate regimes and political institutions of these diverse economies. These differences help determine the extent to which markets are driven by local versus global factors.

As the emerging market debt asset class continues to grow, investors will be forced to revisit their approach to investing. Less than three decades ago, investors wishing to invest in emerging market debt were restricted to a small set of US dollar bonds, mostly from Latin American nations.

Today the four pillars that make up the asset class account for around a quarter of the global bond universe. Yet most global asset allocators continue to invest little in emerging market debt. Moreover, they primarily own US dollar sovereign debt. What are the practical steps investors can consider to take full advantage of this asset class?

Embrace local currencies

The largest and most liquid bonds in emerging markets are now those issued in local currencies. Default risk is negligible for these bonds. However, investors are exposed to the volatility of emerging market currencies. The yield on these bonds can be less sensitive to global capital flows, increasing the diversification potential. But investors must understand the exchange rate regime to assess how independent monetary policy is.

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Investors should select a basket of currencies that they expect to move in tandem with those of emerging economies

To potentially reduce currency risk, investors can fund purchases of local currency bonds using a basket of currencies rather than their base currency. Investors should select a basket of currencies that they expect to move in tandem with those of emerging economies. These could include the euro, sterling and Australian dollar, which also typically depreciate against safe-haven currencies – the US dollar and yen – during a crisis.

Monitor China

China’s debt market is opening up to international investors. The country is grossly underrepresented in portfolios relative to its size and its importance to the global economy. Index inclusion is expected to drive additional flows into the country. It offers attractive yields compared to developed markets of equivalent credit quality.

Explore the frontiers

Countries on the frontiers of investing include some of the fastest growing economies. A number of countries are adopting the political, economic and market reforms necessary to promote growth. This is allowing many countries to issue US dollar bonds for the first time. These issues may come with the support of the IMF or World Bank.

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Engaging with locals is key to building a robust understanding of risks

The involvement of these global institutions provides some comfort to investors that appropriate policies are in place. However, local institutions are less developed than in more mature markets and data quality is less reliable. Investors need to engage with locals to build a robust understanding of the risks.

Incorporate corporates

The emerging market corporate bond universe is less well researched than either government bonds or domestic equities. This creates the opportunity to generate alpha through bottom-up security selection. It is possible to find companies with strong balance sheets and low leverage, offering attractive yields.

The JP Morgan CEMBI Broad Diversified Index, the most commonly used benchmark, is diversified across over 600 issuers in 52 countries. Yet this is a small fraction of the overall market. We expect flows from global investors into emerging market corporate bonds to increase.

Integrate ESG and political analysis into your investment process

Countries with better ESG credentials and stronger political institutions will, on average, pay less to borrow. Reforms that improve transparency, reduce corruption and strengthen central bank independence will help attract long-term capital.

Improving the strength of state institutions helps protect the rights of international investors. This reduces inherent country risk. Investors should monitor changes in these factors to identify attractive investment opportunities.

Pulling it all together

Rapid economic progress in emerging countries is driving growth in debt markets. Today, investors have an unprecedented range of opportunities across over 80 countries. These markets offer the potential for attractive yields to those investors able to assess the risks involves. 

Successfully investing across the four pillars that make up the emerging market debt universe requires a range of skills. Analysis must span government and corporate bonds, US dollar and local currency debt, countries at very different levels of development, and ESG and political risks as well as global economic and political developments.

Low yields across developed markets will continue to drive international investors to seek returns from emerging markets bonds. These investments come with a diverse range of risks. The last two decades have provided a positive backdrop for investors in emerging market debt. Global yields declined and defaults were rare.

Today, debt sustainability continues to look healthy. But markets move in cycles. The next decade will inevitably differ from the last. Investors must carry out fundamental analysis to understand, monitor and manage risk.

We believe that a team with sufficient resources to undertake research across all four pillars of the market can help mitigate these risks. Accessing the widest range of investment opportunities can increase the chances of investors achieving their goals.