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To investors in search of steady income, emerging market bonds offer some of the highest yields around. But not all EM debt is created equal. The asset class represents a huge and rapidly shifting universe of national governments and corporate borrowers, from builders in China to miners in South Africa to meat exporters in Brazil.
The management of exposure to currency risk, credit quality, and corporate or sovereign debt across the EM fixed income space determines the expected stability of returns, a key consideration when investing for income. With the right allocation, investors can expect a stable, well-diversified source of income, often with higher credit quality and yields than some developed market asset classes. Get it wrong and portfolios can suffer higher volatility and credit risk than intended, including the risk of permanent capital loss.
Local and hard currency
The highest yielding part of emerging market debt tends to be local currency denominated bonds. But such bonds also tend to be the most volatile due to fluctuations in foreign exchange rates. For example, a long-term, dollar-based income investor who buys a 5-year Malaysian ringgit bond with a 3 per cent coupon and holds it to maturity would receive a 15 per cent return on their initial investment on repayment. But this natural income can be reduced by unfavourable currency moves. Over the past five years the Malaysian currency has weakened by more than 20 percent against the dollar, enough to completely wipe out the income gains from the bond.
These hard lessons were learned recently by investors holding local currency bonds from Argentina and Turkey. In August last year, the Turkish lira lost a quarter of its value against the dollar, while the Argentinian peso fell by nearly a third.
J.P. Morgan indices are the CEMBI Index for EM $ Corporates, EMBI Global Index for EM $ Sovereigns. ICE BofAML indices are the IUC0 for US Corporates and GI00 for Global Corporates, all as of March 2019. Yields refer to yield to maturity. Source: Fidelity International, Bloomberg, J.P. Morgan and ICE BofAML bond indices, March 2019.
Of course, currencies also strengthen, which provides the potential to enhance returns. And foreign currency exposures can be hedged although this limits the upside as well as downside, while also adding to the overall cost of the investment. And there are ways to combine both local and hard currency instruments in a portfolio designed for income.
Overall, local currency bonds provide a higher-octane investment compared to hard currency bonds, in that they offer the potential for capital appreciation from favourable exchange rate moves, in addition to ‘natural’ income from collecting coupon payments. Some investors may welcome the potential to boost returns, but many income-focused investors prefer the more stable returns offered by dollar-denominated debt. This strips out any direct exchange rate risk while still offering substantially higher average yields than developed markets.
Sovereigns and corporates
At the sovereign level, investors in hard currency EM debt need to get comfortable with a country’s debt servicing risk. At the most basic level, research here focuses on two main factors: a country’s stock of foreign currency reserves and its recurring inflows of foreign exchange from international trade and investment.
There is a wide spectrum on these measures across emerging markets. Indonesia for example has run healthy foreign reserves of more than $100 billion for the past few years, while maintaining dollar inflows from exports of oil and gas, as well as edible oils. By contrast, Pakistan’s government debt has risen recently, partly due to a spike in imports of machinery and capital goods from China. At the same time the currency has depreciated by around 60 per cent in the past two years, and export growth has deteriorated. The result is that Pakistan’s foreign exchange reserves have roughly halved since 2016 to less than $10 billion.
Investors need to choose carefully but a broad allocation to hard currency EM sovereign bonds can provide good diversification by investing across dozens of economies that are in different stages of their growth and development cycles. At the same time, EM corporate debt can provide an additional layer of diversification by adding sector-specific and company-specific exposures.
For sovereign debt, key drivers of alpha and risk include credit and US Treasury risks. Spread movements here are affected by growth momentum, credit quality, fiscal balances, and government debt levels to name a few factors. For corporate debt, risk drivers are similar but include both country and company credit risk. General corporate bond strategies tend to be higher credit quality than sovereign as they focus on investment grade securities (unless of course they employ a specialised strategy like investing in corporate high yield bonds), and also tend to feature shorter duration than sovereign credit.
It should also be noted here that the majority of outstanding corporate EM debt is hard currency. Local currency issuance is mostly confined to sovereigns.
A multi asset view
Another way to think about EM debt is to compare it to other sources of income. From a multi-asset investor’s perspective, equity income strategies offer attractive yields and dividend growth but, compared to EM debt, the equity strategies tend to feature higher volatility and risk. And compared with other categories of fixed income, such as global, US or European corporates, EM debt offers more yield at about the same duration, or level of exposure to interest rate risk.
It may sound counterintuitive, but rotating from developed market to emerging market debt can reduce risk in a portfolio. As hard currency EM debt is mostly rated investment grade, reallocating here from US high yield or European high yield can move portfolios up the credit rating spectrum. EM hard currency debt has also historically exhibited lower spreads and slightly lower volatility than high yield. And in many cases a rotation to EM hard currency would actually mean picking up more - not less - yield.
However, hard currency EM bonds also tend to offer higher dollar duration, meaning they are more sensitive to changes in interest rates. This is a risk but in the current environment where central banks have stopped hiking rates or are even suggesting further easing is coming, the risk of this exposure is positive not negative. Thus, in recent months, amid the prevailing risk-off mood among investors that is pushing down treasury yields, the higher dollar duration of EM debt can be more defensive if carefully managed.
Indeed, rotating between the different EMD categories is key to optimising a portfolio for income, and not just in the current market environment. An allocation that mixes EM sovereign and corporate debt alongside hard and local currency exposures can be a powerful diversifier. It can also offer good yields and credit quality - and be a stable source of income.
So how much bigger can the market for EM debt grow? For a glimpse of the future it pays to watch what is happening in China.
The inclusion of China’s local currency onshore government bonds in major global fixed income indices this year has been a watershed moment for EM debt investors. Previously, China had been a big part of hard currency EM indexes globally - but not local currency ones. That is likely to change, as onshore yields are attractive.
Success is contingent on the market continuing to liberalise. But the tremendous size of China’s onshore debt market will make it arguably the most important area of the local currency debt market for international investors in the coming years. Watch this space.