Emerging Market Debt: The script has flipped

Faster growth, lower debt, tighter budgets and calmer currencies than the developed world, while still offering yields that developed markets struggle to match. The case for considering Emerging Market Debt as a structural allocation, and why country selection remains key.

Emerging Market Debt is still widely treated as a satellite allocation, a tactical exposure to be added or removed depending on the global risk cycle. Yet the size, depth and composition of the market increasingly challenge that approach.

Emerging governments now account for US$28 trillion, or 31% of all government debt outstanding. Including corporate issuers, the total reaches US$46 trillion, close to 30% of global debt, compared with roughly 6% in 2000. Half of government debt is now issued domestically, in local currency, supported by an increasingly deep base of domestic investors. The traditional image of EMD as a relatively small universe of dollar-denominated bonds dependent on the US funding cycle therefore describes only a fraction of the market that exists today.

The universe has broadened as well as deepened. In 2000, 27 sovereigns borrowed on international markets and only two had local bond markets of investable size. Today, both figures stand at 71.
For investors, the practical consequence is important: a single asset class now provides access to three distinct return drivers, local-currency duration, currencies and hard-currency sovereign credit, each responding to different economic and market cycles.
EMD is no longer a niche market. Its scale and diversity increasingly argue for a more structural role within fixed-income allocations.

Over the past two decades, emerging economies have rebuilt their public finances, anchored inflation and deepened their domestic capital markets. The old assumption that higher EM growth necessarily comes with higher inflation and larger external imbalances deserves to be revisited. Stronger growth, healthier debt, greater fiscal discipline and more stable currencies: EM fundamentals increasingly stand out versus Developed Markets.

Emerging economies are forecast to grow by 3.7% this year versus 1.6% in developed markets, while carrying public debt of 73% of GDP compared with 110%. Fiscal deficits are both narrower and improving, while those of developed markets are widening. Inflation, at 3.4%, now stands below the 3.9% recorded across developed economies, a striking reversal of the historical pattern and the result of increasingly credible monetary policy.

More than eight in ten Emerging Market sovereign rating actions are currently upgrades on a rolling six-month basis. Argentina's transition from CCC towards B− is perhaps the most visible example, but the trend extends across the asset class.

Default experience reinforces the point: outside a limited number of well-documented events, Emerging Market sovereign high yield has defaulted at or below the rate of US corporate high yield and is expected to do so again this year.

One-month implied volatility on Emerging Market currencies currently stands at 6.7%, compared with 7.0% for G10 currencies. Two decades of reserve accumulation, floating exchange-rate regimes, deeper domestic investor bases and inflation targeting have significantly reduced what was historically one of the largest sources of risk in the asset class.

Perhaps most importantly, these improvements do not rely solely on a supportive commodity cycle. They reflect a deeper rebuilding of policy frameworks following the global financial crisis: the share of emerging economies operating an inflation-targeting regime has increased materially, while the proportion governed by explicit fiscal rules has risen from roughly one-third to almost six in ten. Such frameworks constrain policy through the cycle rather than at a point in it, which is why we regard the improvement as durable rather than a phase.

Macroeconomic orthodoxy is no longer the preserve of developed markets. In many cases, Emerging Markets have learnt the lessons of previous crises and rebuilt accordingly.

Over three years, EM dollar sovereign debt returned +30.5% and local-currency sovereign debt +28.1%, compared with +10.5% for US Treasuries and +7.0% for euro government bonds. Year-to-date, both Emerging Market segments remain positive, while US Treasuries, euro credit and euro government bonds are negative.

Valuations also remain supportive. Real policy rates are close to 20-year highs, while nominal yields remain well above developed-market equivalents: Latin American ten-year bonds currently yield around 10.1%, versus 4.8% in the US and 3.3% in Germany.

This matters because high starting yields provide investors with an important source of carry: a meaningful part of potential returns can come from simply holding the bonds, without requiring an aggressive decline in interest rates or credit spreads.

This time, the shock did not originate in Emerging Markets. It originated in developed markets: large US fiscal deficits, growing financing requirements and heavy long-dated issuance pushed global long-term yields higher. Emerging assets were affected by this global repricing, rather than by a deterioration in their own underlying fundamentals. Meanwhile, flows into dedicated Emerging Market bond funds have turned positive this year, even though most portfolios remain underweight the asset class.

The Emerging Market Debt universe has never been more diverse. But greater breadth also means greater dispersion, making country selection critical.

• Kazakhstan: Attractive carry from an Investment Grade sovereign
  Kazakhstan combines low public debt with substantial external savings accumulated through the National Fund. Yet its local-currency bonds continue to offer some of the highest yields in the investable universe. In our view, the strength of the sovereign balance sheet is difficult to reconcile with the level of remuneration available.
• Nigeria: Reforms are changing the macroeconomic picture
  Fuel-subsidy removal and exchange-rate liberalisation have restored a functioning currency market and materially improved fiscal accounts. The reform programme is not complete and execution risk remains, but current carry provides meaningful compensation for that risk.
• Argentina: From distress towards conventional high yield
  A sustained primary surplus, a large energy surplus and higher foreign exchange reserves are supporting a transition from distressed credit towards a more conventional high-yield profile.
• Korea : Quality and diversification
  Low public debt, a budget surplus, contained inflation and a persistent current-account surplus provide a fundamentally different opportunity. Won appreciation and index inclusion should support structural inflows into a deep and liquid local market, offering high-quality duration that can help balance higher-beta positions elsewhere in the portfolio.