The business of investing in Emerging Markets debt has come a long way in the past 25 years. Not only has the number of countries covered risen exponentially, but the scale and range of debt issuance has also grown, creating more opportunities than ever for investors.
In December 1998, financial markets were still reeling from Russia’s default and, a year earlier, an Asian financial crisis had upended developing economies all over the world. It was against this volatile and seemingly inauspicious backdrop that Payden & Rygel launched its Emerging Markets Bond strategy.
Since then, the number of countries in one of the most widely used emerging market bond indices has grown from eight to seventy, achieving diverse regional representation from Central and Eastern Europe, the Middle East, Africa, Latin America, and Asia.
Too big to ignore
Today, emerging markets are too big to ignore. The asset class represents a large and growing proportion of the world economy, accounting for over 40% of global GDP in 2022.
The asset class includes a broad spectrum of issuers, with investment opportunities of varying risk/return:
- While sovereigns are still a core option for investors, unlike in 1998 investors today can also gain exposure to a large universe of emerging market quasi-sovereign and corporate bonds.
- Investors no longer need to stick to U.S. dollar or Euro-denominated bonds: they can buy local currency bonds from both established and frontier emerging markets.
Emerging markets debt is not as risky and underdeveloped as many investors believe. About half of the sovereign dollar-pay index is investment grade-rated, and the percentage is even higher among emerging markets corporate bonds (59%) and local currency bonds (79%).
Debt is the better diversifier
Emerging market debt delivers greater diversification benefits compared to emerging market equity, and with much lower volatility. Consider that while emerging market equities have generated higher absolute returns, when adjusted for the volatility, emerging market debt returns are about 40% higher than emerging market equities, over the last 20 years.
As the emerging markets debt universe expands and diversifies, investors have more opportunities to manage volatility. For instance, while sovereign defaults increased in the aftermath of the pandemic, the average emerging market economy has managed to avoid dramatic adverse outcomes such as those in 1997/8 thanks to better economic policy management and stronger external buffers.
Current Outlook
EM fundamentals have been improving since the pandemic, with monetary policy authorities employing a proactive response following the spike in global inflation, and many of them hiking before the Federal Reserve (Fed). This is a novel development; in the last two cycles, EM hiking, on aggregate, was in line with the Fed or lagging. As inflation has declined, many EM central banks have eased their main policy rates in response.
Looking ahead, emerging market growth, per the IMF’s most recent World Economic Outlook (WEO), is expected to be roughly unchanged versus what we saw last year, despite a moderation in Chinese growth. That comes out to about 4 per cent growth on aggregate in emerging markets. Looser monetary conditions should be a supportive factor, for example, on the domestic side of the equation. Externally, we see a continuation of a strong US growth outlook to be positive for emerging markets.
On the fiscal side, although debt is certainly higher than before the pandemic, it does not compare to the debt overhang seen in advanced economies. And in the case of the largest emerging market countries, the current account deficits are a little bit greater than 1 per cent of gross domestic product (GDP) at an aggregate level. We see this as manageable from a funding perspective.
Looking forward
So, in short, the future looks bright. A stable growth backdrop, combined with lower inflation, has resulted in reduced market volatility and overall support for risk assets. That said, we remain alert to geopolitical and country-specific risk factors.
In our view, EM debt offers diversification benefits, and elevated yields have historically generated healthy long-term income for investors. Valuations in EM debt are compelling compared to peer sectors, and we see opportunities across a variety of hard and local currency markets (including frontiers) making this a suitable time to reconsider the asset class.
About Payden & Rygel
With $161.7 billion under management, Payden & Rygel is one of the largest privately-owned global investment advisers. Founded in 1983, the firm manages fixed income and equity portfolios through domestic and international solutions. Advising the world's leading institutions and individual investors, Payden & Rygel provides customized strategies across global capital markets. Payden & Rygel is headquartered in Los Angeles and has offices in Boston, London, and Milan.
Investment in foreign securities entails certain risks from investing in domestic securities, including changes in exchange rates, political changes, differences in reporting standards, and, for emerging market securities, higher volatility. Investing in high-yield securities entails certain risks from investing in investment grade securities, including higher volatility, greater credit risk, and the issues’ more speculative nature.
This material reflects the firm’s current opinion and is subject to change without notice. Sources for the material contained herein are deemed reliable but cannot be guaranteed. This material is for illustrative purposes only and does not constitute investment advice or an offer to sell or buy any security. Past performance is no guarantee of future results.
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