Emerging Market Debt: All Grown Up
Point of View With Sergio Trigo-Paz and Ernesto Bettoni
Emerging markets debt (EMD) has grown up in the past decade. Once viewed as an esoteric niche product, the asset class is now in the process of becoming mainstream—and with good reason. According to BlackRock's emerging market debt experts, this relatively new asset class offers the potential for higher income, long-term portfolio growth and enhanced diversification. In the following report, Sergio Trigo-Paz and Ernesto Bettoni discuss why emerging markets debt is so attractive and also explain how they construct EMD portfolios.
- Emerging market debt combines attractive yield and return opportunities with low historical correlation to traditional areas of the bond market.
- Strong economic growth and fundamental changes in emerging markets over the past decade have improved the quality and stability of EMD.
- With such a broad range of opportunities and risks, deep research, analysis and discipline are crucial to building the right portfolio.
Why consider investing in emerging markets debt? Is now a good time?
We believe emerging markets debt is an asset class that simply cannot be excluded from a portfolio.
In short, we believe emerging markets debt is an asset class that simply cannot be excluded from a portfolio. Emerging markets have changed drastically over the last 10-15 years. A decade ago, crises were the norm, but today, emerging markets have evolved through economic reforms and market developments. These changes have turned this once-niche speculative opportunity into a mainstream strategic investment that represents 12% of global fixed income markets.*
From a timing perspective, we would suggest investors not seek to time the market but to rely on a manager with deeper insight to the opportunities and risks in emerging markets debt. Furthermore, we believe the long term outlook for the asset class is strong and that investors should consider a strategic allocation, particularly in light of the fundamental changes to many of these markets.
How have emerging debt markets changed?
Today's markets stand in stark contrast to the emerging markets of the 1990s that featured a range of defaults, devaluations and currency crises in Mexico, Asia, Russia and Brazil. As you can imagine, the volatility from these crises was quite detrimental to investor confidence in the regions.
Fast forward to the present, and these same markets now have effective central bank policies that better manage inflation, more prudent fiscal management (less profligate spending) and expanded local debt markets.
In addition, in clear opposition to developed economies, emerging markets are not in a mode of seeking to reduce debt, which gives them more fiscal flexibility. As a result of all of these improvements, emerging market governments have experienced steadily rising credit ratings, as seen in the chart above. At the end of 2012, about 65% of the sovereign emerging market debt index was rated investment grade, compared to less than 5% in 1993. Furthermore, fully 90% of the countries in the local debt benchmark JP Morgan GBI-EM Global Diversified Index are investment grade. The high credit ratings could be quite meaningful to investors looking for more attractive alternatives to high quality but low-yielding developed market investments.
All this is not to say investing in emerging markets debt is without risk. For larger, more heavily traded emerging markets in dollar-denominated bonds, investing carries similar interest rate and credit risks as in developed markets. For smaller emerging markets and local debt markets, risks also relate to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments.
What do these changes mean for investors?
They have radically transformed the EMD asset class, making it appealing to a wider array of investors. As these reforms have taken hold, they have fostered greater stability in interest rates, inflation and emerging markets currencies.
With this greater stability, a broader and deeper debt market has emerged, attracting new investors to the asset class. Today the emerging markets debt asset class offers a wide spectrum of investments, making it attractive to investors looking for diversification and alternate sources of income.
Note: Chart represents emerging market debt tied to benchmark indices.
What is "hard currency" versus "local currency" emerging market debt?
In the early growth period of emerging markets debt, governments had to rely on foreign lenders for their borrowing as the local markets and investor base had not yet developed. Because of that, most debt was issued in an internationally recognized currency (generally US dollars), and referred to as "hard currency" debt. Over the course of the past 20 years, the quality of hard currency debt issues has risen such that more than 65% of the category is investment grade. For an investor today, a number of factors can make this segment desirable from the perception of lower volatility. One is the fact that hard currency bonds are less available (more demand than supply). In addition, they do not have exposure to the currency fluctuations and local interest rate environment of emerging countries.
On the other hand, emerging markets debt denominated in local currency offers a different and compelling opportunity. One important difference is that an investor in local debt must have insight into local interest rate trends and have an understanding of local country factors such as inflation, monetary policy and demand and supply of government bonds. In addition, to invest in local currency bonds, investors must hold the emerging market currency in order to purchase the bond, rather than US dollars. This additional level of complexity emphasizes the importance of relying on a professional portfolio manager for emerging markets investments.
The advantages that local currency emerging market debt offer include a more attractive yield relative to hard currency debt, an average credit rating higher than hard currency equivalents and relatively greater depth in trading (easier to buy and sell) as it is a larger market. Furthermore, local currency bond portfolios have the potential to experience currency appreciation. Ultimately, with two potential return engines in currencies and bonds, emerging market local debt has the potential to be powerful for investors in search of new sources of income and returns.
Where do you see opportunities in emerging market bonds today?
Currently we believe the best opportunities exist in local currency debt markets because it is the most liquid, the most diverse, offers attractive yields and holds the potential for currency appreciation. The opportunities for excess returns are greater in local EMD because of the interaction of multiple different monetary policies with different inflation and currency dynamics. We also like emerging markets corporate debt, which can offer yields that are higher than those available from developed markets, and are also attractive when compared to emerging markets sovereign debt.
What is your outlook for interest rates and EM bonds?
From a yield and total return perspective, we believe there are a wealth of opportunities for excess returns in emerging markets debt, particularly in local currency debt.
Let's start with our outlook for the sector. From a yield and total return perspective, we believe there are a wealth of opportunities for excess returns in emerging markets debt, particularly in local currency debt. And as the chart below shows, emerging market debt offers a compelling risk-reward proposition relative to developed market bonds.
Standard deviation measures volatility of returns. Higher deviationrepresents higher risk. Index yields shown for illustrative purposes only. Indices are unmanaged. It is not possible to invest directly in an index. Past performance is no guarantee of future results. Fixed income yields are yield to worst. The rest are current yield. US Treasury represented by Barclays US 7-10 Year Treasury Bond Index. Investment Grade Bonds represented by Barclays Investment Grade Index. High Yield Bonds represented by Barclays HY 2% Issuer Capped Index. Bank Loans represented by S&P Leveraged Loan Index. High Dividend Equity represented by MSCI USA High Dividend Yield Index. Preferred Stock represented by S&P US Preferred Stock Index. US REITs represented by FTSE EPRA/NAREIT Developed Real Estate Index. MLPs represented by Alerian MLP Index. EM debt represented by JP Morgan GBI EM Diversified Index.
Turning to our outlook for interest rates, many emerging markets already reflect fears of higher rates, but since inflation remains quite low in many countries, quite a bit of value exists. We always take a tactical approach to benefit from short term trends so our recent defensive positioning is shifting into a more aggressive stance as opportunities blossom. In fact, we expect the strong fundamental position of the emerging economies to allow them to implement countercyclical policies to support markets. So we believe opportunities in local bonds will continue to be attractive.
Finally, some countries will face inflation while others will not. For the moment, inflation is minimal across most emerging markets so we see value in bonds on an inflation-adjusted basis in some markets. Since interest rates and currencies are so tightly intertwined, we believe some currencies will suffer relative to the US dollar, whereas others will outperform. We've positioned ourselves to take advantage of those opportunities by utilizing our flexibility to distinguish opportunities amid shifting interest rates and currencies.
How do you manage a portfolio of emerging markets bonds?
To help us manage a diverse EMD portfolio, we've created a proprietary scenario analysis tool called the "Global Weather Station" (GWS). This tool helps us analyze market drivers or "storms" impacting the asset class at different speeds, to allow adjustment of asset allocations accordingly. And the GWS works on a forward-looking basis, helping the investment team avoid decisions based on old news that has already been priced into the market. For example, it tells us that inflation is not a driver of returns right now, meaning inflation-sensitive investments are not attractive. Given the diversity of the asset class and the seemingly shorter market cycles than in the past, we believe this kind of insight is critical to successful portfolios. Taking input from this tool, we take a 6-month tactical asset allocation approach to investment decisions. Asset allocation strategies do not assure profit or protect against loss, but we believe offer a stronger way of taking advantage of opportunities. Furthermore, to build portfolios with high conviction, we have built a strong on-the-ground regional coverage team of contacts who facilitate the deep research and enhanced local market knowledge needed for successful investments.
How is your investment team structured?
Our team has been together for a number of years, and has built a strong track record through our extensive experience and the work we've done to refine the investment process. The refinement we've done over the years has been critical in allowing our portfolio managers to act more effectively on the intelligence we pull from our data sources and contacts. An important part of what we've done is to divide specialties. With six senior portfolio managers dedicated to distinct components of the emerging markets space, the team is able to optimize the different trading styles and time horizons necessary for management of various currencies and different bond sectors. For example, currencies are managed on a one- to three-month horizon, and government bonds on a 6- to 9-month horizon. Sergio Trigo-Paz, as lead manager, oversees the portfolio managers and the process, and makes capital allocation decisions to each component. We believe this is the most efficient way to incorporate the themes and intelligence as well as the differences across geographies, currencies and bonds.
How should investors access EMD?
Clearly the evolution of the asset class has been fast and has left many investors underinvested. Investment flows have been strong since the financial crisis and we expect they will continue to be strong, but they have a cost: the volatility that is associated with global markets. Because emerging markets debt has become more of a mainstream investment, it now has to deal with the volatility that comes with being a member of the global markets. So investors require a professional approach that can apply scenario analysis while combining global and local themes to be able to read the market better.
Any final thoughts?
The growing emerging market debt universe offers a diverse set of opportunities for investors seeking higher income, capital appreciation and enhanced diversification. With emerging market debt now a significant share of world fixed income markets, investors should consider a strategic allocation to the asset class. Adding the BlackRock Emerging Market Local Debt Fund to a traditional portfolio can help enhance the overall results, increase diversification and offer exposure to countries that are at different stages of the economic growth cycle. Investors should note that diversification strategies do not ensure a profit and may not protect against losses in a down market. An allocation to emerging market debt should be considered within the context of a broader portfolio and in consultation with a financial professional.
An allocation to emerging market local debt is for:
- Investors seeking income and capital appreciation
- Investors searching for an alternative to traditional core bond strategies
containing heavy interest rate risk
- Investors underweight emerging market exposure
EM Debt Offers Diversification from Traditional Fixed Income
Correlation to Asset Classes Over 3- and 5-Year Periods
|Traditional Core Fl||-0.01|
|Sterling Agg Bond||-0.09|
|Traditional Core Fl||0.41|
|Sterling Agg Bond||0.28|
Source: Morningstar. As of 1/31/13. A 1.00 correlation between two asset classes means the two have perfect positive linear dependence. A 0.00 correlation means there is no linear relationship between the behavior of the two assets.
For further insights into emerging markets, please see the BlackRock Investment Institute report.
About the Author
Managing Director, Head of Emerging Markets Fixed Income Team
Director, Product Strategist for Emerging Markets Debt Team
Related by Topic: Investing for Income, Fixed Income
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* Bank for International Settlements, March, 2012.
Investment involves risks. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities (high yield or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets.
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