Author: Kristin Ceva, CFA
EM debt offers significant opportunities, and its risk profile can be misunderstood, argues Kristin Ceva, CFA
With the volume of developed-world negative-yielding debt rising to unprecedented levels, (some $16.5 trillion in August 2021, according to the Financial Times), investors are increasingly looking elsewhere for income, particularly to emerging markets (EM).
Portfolios of EM sovereign bonds are typically yielding between 5% to 7%, a big difference from developed world debt. There is also a valuation argument to be made for EM, given that US credit markets are at historical highs while EM debt is not.
Perhaps the principal concern expressed by potential investors about EM, particularly EM debt, is the perceived high risk arising from volatility, combined with low credit quality, but this is a misunderstanding of the opportunities this investment segment offers.
Diversification and Credit Quality
There are 80 countries in the EM universe, so it is straightforward to build a well-diversified portfolio with, for example, exposure to countries in Latin America, Asia, Europe, Middle East, and/or Africa. Furthermore, the risk/return Sharpe Ratio for EM debt is significantly higher than for EM equities, which surprises many investors. In fact, over the last 20 years EM bonds have achieved the same annualized total return as equities but with one third of the volatility.
In terms of low or high credit quality, about 60% of the EM debt asset class is now investment grade. A wide range is available from high-quality countries in the A-rated category such as UAE, Qatar, China, to the single B countries like Sub-Saharan Africa or Mongolia. So, a portfolio can be constructed that has elements across many different types of countries and ratings.
Three Asset Classes
There are three different asset classes under the heading of EM fixed income. On the dollar pay side, there are sovereigns or government debt - lots of opportunities, both in investment grade and high yield space across those markets.
Additionally, there is the corporate market, which has grown tremendously over the last five years. Today, there are over 600 tickers to choose from in the emerging market corporate space across many different industries in many different countries. These trade at additional spread to sovereign debt. Then in the local pay market, these are countries that issue in their own local currency. The total return stream here is different reflecting both what is happening to the yield side, and equivalently to the currency of a particular bond.
Liquidity in EM debt naturally varies because this is a complex asset class. There is quite a lot of liquidity in many local markets, such as South Africa or Russia which are well-established and well-traded. By comparison, there is lower liquidity in, for example, some of the frontier markets. It depends on whether one is looking at sovereigns or corporates, and within these the more-established, larger issuers versus the newer frontier markets that have issued less outstanding debt.
From an emerging market ESG perspective, the ‘G’ in governance is very important. For example, in our analysis of China, the governance side is something that my team and I are paying very close attention to. We think the government is looking to achieve a better income distribution. They want few people at the top, few at the bottom and most people in the middle-income space because they think that growth is going to be driven by consumption of the average person. A lot of the changes in tech, for instance, are occurring because the Chinese government does not want the tech field to be dominated by the ultra-wealthy. Equivalently, the private education changes and the tutoring changes are really about wanting things to be affordable so people can have more than one child.
Of course, there are other things going on in China on the human rights side that are very concerning, so any analysis must take account of many different factors. But the best way to understand the regulatory changes that are taking place is through the lens of the promotion of that consumption-led growth path.
ESG analysis of emerging markets has always been critical. When putting together a scorecard on a country, ESG factors, many of which are qualitative, are a very significant component – typically a 30% to 40% weighting. And good ESG scores tend to drive market performance in many different circumstances.
Uruguay is a good example of an attractive investment opportunity underlined by its improving ESG trajectory. It ranks in the top five globally on low emissions per capita, and first in Latin America on corruption perception. It continues to be a strong democracy with stable political transitions, and that has helped it also to manage the COVID crisis quite well. Angola is also on the up, having recently emerged from four decades under the Do Santos administration to a new government that is creating a better business environment, conducting privatisations, and really addressing some of the high-level corruption issues in the country.
The emerging markets investment segment is under-allocated, it is 60% of overall global GDP, but only 15% of global debt markets. So there are still a lot of institutions with little or no EM debt exposure. That said, the income generated by the EM sovereign asset class is one reason why many now view EM as a strategic asset class and not something tactical to trade. And that view should be linked to the fact that the risk/return – the Sharpe Ratio of EM debt - looks so favorable compared to almost every other asset class in the public markets over time.
Kristin Ceva, CFA is portfolio manager of the Payden Emerging Markets Bond Fund.