Emerging market debt: A useful tool for multi-asset portfolio diversification

In this article, we run through the types of emerging market debt (EMD) and discuss the pros and cons of having the asset class as part of a multi-asset portfolio.

EMD encompasses fixed income securities issued by governments (sovereigns), government-connected entities, such as state-owned businesses (also known as quasi-sovereigns), and companies based in emerging markets. These EMD securities can be issued in either hard currency or local currency:

This is EMD issued in commonly traded developed market currencies, such as the US dollar and euro. Issuing in these currencies reduces the risk for the bondholders whose base currency matches the issuance, by removing currency risk. As such, this segment of EMD is often less volatile. In the past, returns from hard-currency EMD have often been greater too. However, there is relatively poor liquidity, and it has a weaker credit ratings profile. Hard-currency EMD is often influenced by US interest rate cycles to a greater degree than the local-currency EMD alternative. For example, an increase in the US fed funds rate could hit valuations and increase payments on variable-rate debt.

These are bonds issued in the local currency of an emerging market borrower. For bond holders, there is currency risk as well as the overall credit risk of the issuer. However, the bonds have a lower correlation with interest rate changes in developed markets like the US. Local-currency sovereigns are instead most impacted by domestic factors. Local currency EMD is the largest segment of the EMD market, and these bonds are typically issued by relatively robust emerging markets, with stronger economies and relatively stable inflation and currencies. This backdrop gives the issuer the confidence to issue in their local currency. Overall, default rates tend to be lower for local-currency EMD compared with their hard-currency equivalents.

EMD is an important element in many global multi-asset portfolios, aiding diversification, and often delivering a yield uplift.

Yield – Often EMD comes with an attractive yield when compared with developed market debt. This is because of the additional risks of investing in emerging markets, as volatility is usually higher.

Diversification – This benefit comes from EMD’s relatively low correlation with other asset classes as emerging markets often have different economic cycles, market drivers, dynamics, and political regimes. As such, it can be a useful tool in the multi-asset allocation toolbox.

Long-term potential – EMD can benefit over the long term from structural, market and political reforms in their home market. Currency gains and fiscal positions could help economic growth, business growth and market returns over the long term.

Volatility – Dynamics that often include higher political uncertainty, economic vulnerability, and lower market liquidity can have a large impact on asset values. Additionally, commodity prices are often a big influence on emerging market economies, as many emerging markets are commodity exporters and commodities prices are also often volatile.

Currency – Local-currency EMD brings currency risks to investors. Currency movements here can add to losses (or bolster returns) for investors outside emerging markets. Similarly, for bonds issued in, for example, US dollars, there would also be currency risk for non-US investors.

External factors – EMD can be vulnerable to global issues, including the risk appetite and asset allocations of global investors, and the US rate cycle. with US interest rate decisions and interest rate levels. Similar to the developed market corporate bond market, EMD credit spreads show the extra yield investors want for investing in the emerging market, compared with a perceived risk-free alternative, such as a US Treasury. This means that, for example, when yields widen, relatively risky EMD is experiencing lower demand.

Credit quality – EMD often, but not always, has lower credit quality than debt in developed markets.

Liquidity – As with some other bond types, there can be occasional drops in daily trading volume.

EMD is an important element in many global multi-asset portfolios, aiding diversification, and often delivering a yield uplift. Given the particular opportunities and risks it can represent, multi-asset managers and other investors need to analyse the drivers and risks that this asset class represent.