The changing face of emerging market debt

December, 2012 Print


Alexander Kozhemiakin

Director of Emerging Market Strategies

Standish Mellon Asset Management LLC


The emerging market debt investment universe has grown significantly over the past 25 years and now includes over 50 countries. The asset class’ investor-base has also grown and widened, particularly since the onset of the sovereign debt crisis in europe writes alexander kozhemiakin, of standish mellon asset management


As emerging market debt matures and becomes more “main-stream”, investors increasingly consider it part of any well-diversified portfolio.

They have also become more discerning, realising that country differentiation is key for any successful investor in this area.

Compared to the equity market, the debt market is weighted very differently across the key emerging market regions and countries. While Asian economies have a large share in the emerging market equities, the most important regions for emerging market debt are Latin America, Eastern Europe and Russia. This is because Asian countries, including China and India, issue very little government debt, with limited quasi-sovereign issues available.

Investors also appreciate the fact that emerging market debt’s fundamentals look particularly favourable against the backdrop of sovereign debt problems in the developed world.

Gradual changes and readjustments to global financial and economic conditions, which have been gathering momentum over the last 30 years, were put into a spotlight by the global financial crisis and the slow and painful recovery which followed. As developed world governments increasingly took over banks’ liabilities, traditional notions of “riskfree” sovereign debt in advanced economies and “riskier” sovereign debt in emerging markets no longer appear to be applicable.

Credit quality

Declining incomes, growing debt and credit risk downgrades have all underlined heightened risks of investing in advanced economies. In the meantime, emerging economies have continued to be supported by particularly strong and improving credit fundamentals.



Their sovereign credit strength has seen notable improvement thanks to debt, strong fiscal position and low pension liabilities. In the early 1990s, “high quality”, investment grade bonds – those rated BBB by Standard & Poor’s and above – accounted for about 3% of the emerging market bond universe. Today, they make up more than 60%. So far in 2012, 80% of new issues have been investment grade*. Put another way, the risk of default is considered to have been greatly reduced for most emerging market governments.



The transformation seen in emerging market debt over the past decade not only affected by investors’ perceptions but has also led to a change in the composition of the asset class.

Whereas at the start of this century the asset class consisted almost entirely of US dollar-denominated sovereign bonds, issuance of local currency emerging markets debt now outstrips hard currency debt issuance.

Meanwhile, investors are increasingly able to explore opportunities in emerging market corporate bonds, rather than being largely restricted to sovereign debt.

While emerging market debt fundamentals are strong, it is a complex asset class, with the performance of hard currency and local currency bonds being driven by different factors.

Hard currency debt: performance driven by credit fundamentals

The performance of US dollardenominated sovereign debt tends to be based on credit dynamics and its main source of returns comes from spreads over US Treasuries.

Most hard currency emerging market debt is denominated in US dollars and includes bonds issued by governments (sovereign debt), state-controlled companies or corporate bonds guaranteed by governments (quasisovereign debt), as well as corporate debt.

The most commonly used benchmark for US dollar-denominated emerging market debt is the JP Morgan Emerging Markets Bond Global Index, which comprises debt securities issued by governments of 50 countries, as well as quasi-sovereign debt instruments issued by state-controlled companies. The index includes 320 debt instruments with total capitalisation of over US$550 billion (Source: JP Morgan as at 28 September 2012).

We believe that in the current market environment, spreads on US dollardenominated emerging market debt look relatively attractive, as they seem to compensate for the underlying credit risks given the average quality rating of BBB- for these bonds. The outlook for hard currency debt is also supported by the ability of emerging market central banks to loosen policy, both monetary and fiscal, if and when further stimulus is required.

Local currency debt: benefiting from emerging markets’ strength

For some time, investment in emerging markets debt has tended to focus on US dollar-denominated debt instruments. However, over the past few years investors have been moving their attention to local currency debt.

In contrast to hard currency debt, its performance is inherently linked to improving economic health, inflation dynamics and the performance of local currencies. Over the last ten years, local currency debt has an impressive performance record relative to developed market assets*, partly because it is less affected by the fortunes of the developed world and therefore presents strong diversification benefits relative to other fixed income investments.

This quality is being recognised by investors. Over the last five years, the market value of local currency debt has more than quadrupled to over US$930 billion*, and now represents approximately two thirds of the total emerging market debt investment universe.

That said, the JP Morgan Global Bond – Emerging Markets Global Diversified Index, a benchmark used for tracking the performance of local currency debt, covers considerably fewer countries compared to its hard currency counterpart. It comprises 171 debt instruments with the average credit rating of BBB+

Emerging market currencies strengthened over the past few years but we see scope for further local currency appreciation because of the positive demand and supply dynamics. We think that some local currencies are still generally more attractively valued than a year ago.

Those sell-offs in the market which brought emerging markets currency valuations down in September 2011, and again earlier this year, started in the Eurozone and were driven by a general ‘risk-off’ sentiment, unrelated to emerging market fundamentals.

When we look at our key underlying economies, we continue to see healthy current account surpluses and strong foreign investment inflows, which are the two key performance drivers for local currencies.

Assuming modest currency

appreciation, emerging markets local currency bonds have the potential to continue to generate consistent positive returns. Local currency sovereign debt increasingly prices in interest rate cuts, while inflation remains lower than many market participants expect, chiefly due to a moderating economic growth outlook.

The growing market of emerging market corporate debt

While sovereign debt issuance has remained relatively stable over the past decade, with demand outstripping supply, corporate debt issuance has seen impressive growth and we expect investors to focus on this market more as it deepens and becomes more diversified in terms of credit quality available. Corporate debt is issued mostly in hard currency, with only a small proportion in local currency.

Over the past few months, new issues from corporates have been plentiful, many of which we believe look attractive, particularly those issued in countries which we favour but whose pure sovereign bonds are seem relatively expensive.

The long-term outlook for emerging market countries remains brighter and their sovereign balance sheets more sustainable than in the developed world. As always, over the near term, the performance of the asset class will be dictated by swings in the global risk appetite. However, we believe longterm investors should be encouraged by the inflows into emerging markets local currency debt over the past few years, as well as by the willingness of at least some central banks to step into the market to temper currency fluctuations.

For further information, please contact Kenneth Tomlin.

* Source: JP Morgan as at 28 September 2012.

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