Technical and Fundamental Factors Paint a Rosy Picture

Emerging markets (EM) debt, in various forms, posted admirable returns in 2023. The most commonly cited form – US dollar denominated sovereign debt – benefited from the late year rate rally and posted a total return of +11.1% for the year. That was more than 550 basis points (bps) better than US aggregate investment grade bonds, 270 bps better than investment grade US corporates, and approximately 700 bps better than intermediate Treasuries. EM local currency sovereign bonds did even better than dollar-denominated sovereigns, outpacing the other asset classes listed above by an additional 160 bps, and without the benefit of a sustained EM currency rally. EM US dollar denominated corporate bonds did not fare as well as sovereigns overall, and both the investment grade and high yield components lagged their US corporate counterparts, but both still enhanced returns as satellite additions to core bond allocations.¹

Given the higher yields available in EM and, in aggregate, stronger debt fundamentals versus DM counterparts, the overall outperformance in 2023 (and over the entire two-year period of 2022 and 2023) is not surprising². What might be surprising is that EM debt funds suffered consistent outflows throughout both 2022 and 2023. Flows out of dedicated hard currency EM debt funds were $45 billion in 2022 and $25 billion in 2023, while dedicated local currency debt funds saw outflows of $45 billion in 2022 and $9.0 billion in 2023. At the same time, net supply of EM dollar denominated sovereign and corporate debt shrank as well. Net new issuance in EM dollar sovereigns was only $21 billion in 2023, after registering -$28.6 billion in 2022. For EM dollar denominated corporates the numbers were -$157 billion in 2023 and -$259 billion in 2022. As the EM debt universe continues to mature in a variety of ways, apparently another important development is that outperformance is no longer driven exclusively by “hot money” flows. In fact, 2023 appears to have been a year of outperformance that was also characterized by an improving technical picture.

EM Debt Dedicated Cumulative Flows (US$, bn)

Source: EPFR, Morgan Stanley Research.

Both US high yield and municipal bond asset classes also witnessed net outflows in 2023, but US Treasury and Aggregate funds experienced significant inflows, particularly into ETFs, representing the majority of some $220 billion that came into taxable bond funds. That number does not include money market funds, which took in nearly $1 trillion in 2023! We believe that the favorable technical picture, combined with the attractive fundamental profile of EM debt, sets the stage for another year of potential outperformance versus DM bonds. Investors who are under-allocated to the asset class may want to consider increasing their exposure within their global bond portfolio.