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Payden-Rygel-Kristin-Ceva

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Why emerging market debt?

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Payden & Rygel’s Kristin J Ceva writes that it is important to start out with establishing what Emerging Markets are not. 

EMs are not a backwater in terms of economic activity. In 2021, EM GDP accounted for 58 per cent of global GDP (in purchasing power parity terms) or almost 40 per cent ex-China. At the end of 2021, of the 20 largest economies (in 2021 dollars) half are from the Emerging World. This includes China, which is the globe’s second largest economy behind the United States, but it also includes the likes of India, Indonesia, Mexico and Brazil.

A second misconception is that Emerging Markets Debt (EMD), as an asset class, is underdeveloped, and therefore risky. However, much of the universe is comprised of investment grade issuers. Within the sovereign dollar-pay index (J P Morgan’s EMBI Global), nearly 59 per cent of the index is investment grade. The percentage is higher within EM corporates and EM local at over 65 per cent and 76 per cent respectively. This is part of the secular case for EMD – the investible universe of countries has matured over time.

Under allocation

Though EM economies continue to grow, there is an under-allocation to the asset class. Indeed, EMD in institutional portfolios is limited – in our experience across institutional clients, we see 4-6 per cent as a “full” allocation to EMD, which corroborates other allocation research. However, we observe that many institutions maintain a 2-3 per cent EMD allocation, and that many institutions have no EMD exposure.

These allocations are modest given that traded sovereign and corporate dollar-denominated debt totals approximately USD2.0 trillion. If one factors in EM local currency denominated sovereign debt, that total grows to nearly USD6.0 trillion. This gives a sense of the EM investible universe and compares favorably to peer asset classes like US High yield. 

Diversification not concentration

There is a more qualitative consideration that falls beneath the diversification umbrella. When an investor buys an EMD portfolio, there is the possibility of gaining exposure to almost 90 countries (including both the sovereign and corporate universe), a sizeable increase from the 10 countries that were investible in the early 1990s. This is particularly significant in contrast to the other large EM asset class, equities.

In the main EM equity index, only 24 countries are represented, and the market concentration is high. Within the MSCI EM equity index, the top five countries comprise 75 per cent of the market cap; China and Taiwan alone represent over 40 per cent. In contrast, within the J P Morgan EMBI Global (sovereign dollar-pay index), the top five country exposures are only 41 per cent. Various blends of EM sovereign, corporate, and local currency debt are similarly less concentrated.

EM debt also offers better returns per unit of risk versus EM equities. Over the past 20 years, the main EM equity index has approximately 2.5 times the volatility of the main hard currency EM debt indices (sovereigns or corporates). While EM equities have generated solid absolute returns over this time, when adjusted for the volatility EM debt returns are almost 40 per cent higher than EM equities.

Differentiation in times of war

In a world of about 90 investible EM countries, there is space to differentiate among the opportunity set regardless of the global macroeconomic backdrop. EM aggregates hide plenty of variation and, in the current context, it is worth understanding the relative strength of EM sovereigns.

When the Russia-Ukraine conflict initially erupted, one of our first exercises was to determine which countries would be the most vulnerable to this shock. Two factors stood out:  a) proximity – countries near the conflict zone would perform poorly even if not directly involved; and b) the commodity supply shock. 

In this context, countries that benefited from selling commodities would be well positioned, where those that were large importers would suffer. For example, Latin America, on a regional level was a ‘winner’, with many of the economies in South American being large commodity exporters Another point that stood was that that many of the largest commodity importers were the smaller, lower-rated economies.

The wind may be changing

Market technicals have turned from a headwind to at least more balanced, with the possibility of becoming a tailwind. Over the course of 2022, EMD managers accumulated historically elevated cash positions, and sentiment had become universally bearish. Outflows from EMD had been large and persistent for eight consecutive months. Just as technicals  exacerbated the sell-off through most of 2022, they may now benefit the recovery.

From an EM local market perspective, the opportunities ahead look bright. Inflation momentum is decelerating, central banks have hiked aggressively, and EM currencies have exhibited resilience. Valuations in the US dollar are stretched, and the Fed’s aggressive tightening stance is likely to let up. Investors look likely to earn attractive carry in local markets with a potential for yield compression as central banks turn to easier policy, particularly should downward growth pressures become more pronounced. 

In the corporate space, investors are receiving additional carry in EM relative to US corporates in the same rating category, while, on a fundamental basis, EM corporates also offer greater spread per turn of net leverage versus US corporates. 

In EM sovereigns, there is scope for healthy returns from select high-yield rated countries that benefit from elevated commodity prices, that have policy “anchors” like the IMF, that are less reliant on external financing, and/or that stand to benefit from the predicted growth upswing in China. Examples include the Dominican Republic, Ivory Coast, Angola, Paraguay, Costa Rica, Uzbekistan and Mongolia. Investment-grade rated sovereigns like Mexico, Indonesia and Romania also have potential to offer good compensation. 

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