In the wake of the global financial crisis, financial advisers have been faced with the unenviable task of generating income and attractive returns for their clients in a world where yields on many fixed-income securities have been at or near historical lows, some even offering negative yields.
Financial advisers have, in many cases, grown more comfortable with “riskier” asset classes as they seek to find returns that satisfy their clients' needs. Emerging-markets debt, still a relatively new addition to the asset allocation toolbox of many advisers, is often lumped in with these. But such an all-encompassing view of EM debt fails to reflect the full range of opportunities offered by this growing and increasingly diverse asset class.
The EM debt market has more than doubled in size since 2007 and at approximately $8 trillion exceeds both the $7.6 trillion global-investment-grade corporate-bond market and the $3.5 trillion global-high-yield bond market. The investible universe is composed of three subasset classes: sovereign hard-currency bonds, which are government securities, typically denominated in dollars or euros; local currency bonds — also government securities but denominated in a country's local currency — and corporate bonds, which are typically issued in dollars or euros by large domestic and multinational companies.
DOUBLED IN SIZE
In addition to its impressive growth, the composition of the EM debt market has changed over time. Fifteen years ago, corporate issuance in emerging markets was a small fraction of the total hard-currency market as sovereign issuance dominated. While both have grown over that time, the size of the corporate market eclipsed the sovereign market in 2010 and hasn't looked back; today it is more than double the size of the sovereign market, and consists of many global powerhouses. Such names as Cemex, Teva Pharmaceuticals and Hutchison Whampoa headline today's EM debt market.
Credit quality has improved markedly over time. For example, in 1998, over 90% of the emerging-markets sovereign universe was rated below investment grade; that number was less than 40% as of March 2015, according to Bank of America Merrill Lynch. In the corporate segment, the trend has been similar. Geographic diversity has also improved; for instance, the corporate market was once dominated by Latin American issues but is now split close to evenly between Latin America, Asia and Emerging Europe, Middle East and Africa.
INCREASED OPPORTUNITY
Perhaps the greatest impact of this market's development from an investment standpoint has been the increased opportunity set available for emerging-markets fund managers as they seek to construct portfolios for their clients. There are some obvious attractions for investors. The yield premium on offer is notable. At an index level, EM corporates were yielding over 5% as of April 30, with investment-grade names offering investors a spread of roughly 70 basis points over similarly rated U.S. debt. For high yield, that spread stood at 229 basis points. EM sovereign- and local-debt index yields, at roughly 6.4% and 5.4%, respectively, also look compelling in the context of low developed-market yields.
Diversification is another key benefit. As developed markets have continued to experience relatively sluggish economic growth, financial advisers have been hard-pressed to gain exposure for their clients to the higher growth economies in Asia, South America, Africa and other regions. With interest rate and economic cycles that vary from developed markets, investments in emerging markets can potentially offer low correlations with some of the asset classes that financial advisers typically manage on behalf of their clients.
The potential benefits do not come without risks. Emerging markets tend to be more susceptible to geopolitical risks and cor- porate governance issues. They also can be disproportionately affected by changes in currency values and interest rates. However, with the growth in size and diversity of the EM debt universe, it has become increasingly difficult to paint all emerging markets with one broad brush.
IMPACT OF OIL PRICES
When oil prices fall, it certainly weighs on both EM oil companies, as well as the sovereign debt of oil-exporting countries. But the flip side is that oil-importing countries, of which there are many in the EM universe, receive an almost instant economic stimulus, as do corporate sectors tied to consumer spending. Similarly, as a rise in interest rates in some developed markets draws closer, the impact is unlikely to be identical for all emerging markets. For instance, countries such as Mexico are likely to benefit from higher economic growth in the U.S., and more broadly, many EM countries have floated their currencies in the past decade, making them potentially less susceptible to a stronger U.S. dollar and higher rates.
With such a broad and deep universe of country and company debt to invest in, it is increasingly difficult to sum up the prospects of all emerging markets with catch-all statements. Rather, success today in EM debt investing calls for rigorous credit analysis of both countries and companies in order to truly understand not only the risks, but also the opportunities.
Ricardo Adrogué is head of emerging-markets debt and Brigitte Posch is head of emerging-markets corporates for Babson Capital Management.
