The first half of 2017 has been marked by gluttonous demand for Emerging Market (EM) bonds, with record year-to-date volumes traded for the asset class, and still counting.
Investors' demand for EM debt has been spurred on by a continued search for credit yield enhancement in an environment of persistently low-to-negative global interest rates as the recovery from the global financial crisis trudges on.
Amidst the flurry of investor activity, it’s important to remember that EM debt is not the monolithic asset class it was once thought to be. We lean on top-down economic analysis and a quantitative based approach to identify pockets of value within the EM sovereign debt market (Chart 1). It’s equally important to bear in mind the distinction between a country’s local and foreign currency denominated debt and the various risks associated to both.
Chart 1: Futuregrowth EM Risk Monitor
Source: Futuregrowth Asset Management, Bloomberg
To understand this distinction we need to wind back to the year 1989, which brought with it the advent of EM debt as a truly tradeable asset class with the introduction of Brady Bonds, named after Nicholas Brady – then United States Secretary of the Treasury. These foreign currency denominated bonds, primarily issued by Latin American emerging markets, were introduced in an effort to restructure the distressed debt of these nations and, over time, facilitate greater secondary market tradability of EM debt. Although providing the benefit of access to global financial markets at the time, the issuance of foreign currency debt burdened these sovereigns with foreign currency risk in an environment where these issuers have no control over money supply.
Today, given the benefit of well integrated and globalised financial markets, the expansion of EM debt as an asset class has allowed these sovereigns to largely escape the so-called “original sin” of debt, where a local sovereign issues debt in a currency other than its own. Local currency debt issuance allows for the transfer of currency risk from a sovereign issuer to a foreign investor, and generally allows for local governments to issue bonds at favourable pricing relative to foreign currency denominated issuance.
The development of the EM bond universe, coupled with the rapid economic growth of the EM World relative to that of the Developed World in the last decade has resulted in the transformation of EM debt as a niche asset class in the Brady era to a $12tn behemoth, with market expectations of a tripling of outstanding debt over the next five years – unsurprisingly dominated by local currency issuance. An estimated 35% of emerging market bonds relative to total global bond issuance pales in comparison to the EM’s near 60% contribution to global economic growth. Medium term expectation for a continually positive growth divide between the EM and Developed Market (DM) universe will provide scope for the continued growth of the EM debt universe over the medium term.
This improved macroeconomic backdrop is not only evidenced by favourable EM growth dynamics, but so too by improved external vulnerability metrics for the broader EM universe. We need to look no further than the “Fragile five” nations of Brazil, Indonesia, South Africa, Turkey and India, so termed in 2013 as a result of their burgeoning twin deficits (cumulative current account and fiscal account balances) and related macroeconomic vulnerability. A confluence of often painful currency devaluation, fiscal discipline and growth enhancing policy reform in the intervening four years has long since accounted for the irrelevance of the “Fragile five” moniker.
On a forward looking basis, we remain of the view that the US economy is well primed for a continuation of the Federal Reserve’s steady and well telegraphed interest rate hiking cycle, which global financial markets will continually take in their stride. Meanwhile, China’s serially deteriorating growth trajectory, exacerbated by skyrocketing external debt metrics remains a major source of systemic EM risk.
In a global fixed income context, EM debt therefore offers attractive credit yield enhancement and a measure of diversification against rising DM interest rates – primarily so for foreign currency denominated debt which, by its nature, is immune to currency hedging costs (Chart 2). However, an investment approach combining strict selectivity based on fundamental macroeconomic research and underpinned by a deep qualitative understanding of EM dynamics is required to harness the best value from this dynamic and fast-evolving asset class.
Chart 2: The diversification benefit of EM bonds in a Global Fixed Income Context
Source: JP Morgan