The Case for Emerging Markets Debt: Why Invest in EMD?

The Investment Case for Emerging Markets Debt

Emerging markets debt (EMD) represents one of the most compelling – and most misunderstood – opportunities for global investors.

Despite strong underlying fundamentals and historical performance, EMD is frequently overlooked and under-allocated as a fixed income asset. Under current market conditions, we believe EMD deserves to play a bigger role in global portfolios.

What positions EMD as such as strong fixed income investment?

First, in a world rightly concerned about excessive debt and insufficient yields, EMD has an answer: Emerging market governments are subject to debt constraints and pay market-determined yields.

Second, we believe EMD has “worked” for over a decade – we note that backward-looking efficient frontiers (which shows the optimal portfolio of asset prices that offer the highest expected return for a given level of risk) tell investors to have far more EMD¹ versus a current, average allocation of an institutional investor.

Third, market structure in EMD is characterized by liquidity, default rates and recovery values that are in line with many developed market (DM) bond markets.

In “The Investment Case for Emerging Markets Debt,” we show why EMD has such a strong outlook, why it represents a high-yield investment, and how to develop your EMD strategy.

Topics in this white paper include:

• Why emerging markets have stronger fundamentals than developed markets.
• Why historical performance of EMD points to higher allocations.
• Liquidity, default rates, and recovery rates of EMD.

Want to learn more before downloading the full white paper? Below, you’ll find a summary of our core findings and why we believe investors should consider an allocation to EMD.

1. Emerging markets have Stronger Fundamentals Than Developed Markets

The age-old debate between Emerging Markets and Developed Markets has taken an intriguing twist. Contrary to the historical norm, EMD showcases stronger fundamentals than the developed markets. While developed markets grapple with a higher debt-to-GDP ratio of 126.5%, emerging markets have a moderate 69.4% debt-to-GDP ratio. Emerging market fundamentals look compelling relative to developed markets across a range of additional metrics, including fiscal deficits and current account deficits. Emerging market debt (EMD) also boasts higher yields ranging from 6.79% to 8.24%^* and significantly outpacing developed markets. This shift underscores a pivotal narrative: In a world wary of escalating debt in developed markets, EMD is emerging as a beacon of fiscal responsibility.

Key Points:

• While developed markets grapple with a higher debt-to-GDP ratio of 126.5%, emerging markets have a moderate 69.4% debt-to-GDP ratio.
• EMD also has higher yields, ranging from 6.79% to 8.24% and significantly outpacing developed markets, even the U.S.
• In a world wary of escalating developed market debts, EMD is emerging as a beacon of fiscal responsibility.

2. Historical Performance of EMD Points to Higher Allocations

The efficient frontier has long been a compass for investors, helping inform the optimal mix of assets that yield the highest returns for a set risk. We analyzed fixed income asset classes, from Treasuries to high yield, to evaluate the ideal role of emerging markets debt. Our analysis from 2003-2022 concluded that Emerging market hard currency, with similar returns, bears only half the volatility of U.S. High Yield. While no one questions high yield's significance in a portfolio, EMD’s role often remains underplayed. However, when gauging optimal allocations, EMD should command more prominence than is traditionally granted by institutional investors.

Key Points:

• From 2003 to 2022, emerging market hard currency, with similar returns, bears only half the volatility of U.S. High Yield.
• Despite these strong risk-adjusted returns, most investors remain under-allocated to EMD.
• When gauging optimal strategic allocations, EMD should command more prominence than is traditionally granted by institutional investors.

3. Liquidity, Default Rates, and Recovery in EMD

Emerging markets have been cast in shadows by investor apprehension, often magnified by political risks. Diving into liquidity, both U.S. and EMD corporates dance on the same global financial stage, with EMD boasting an additional market-making advantage. Yet, to pit one against the other in liquidity terms is a misdirection; both harbor risks, but EMD's appear tamer. Supported by robust reserves, emerging markets have mechanisms to address fluctuations, revealing their strategic strength. Their sovereign issuance is also more contained compared to the U.S., ensuring better manageability. And as for default rates and recovery? EMD default rates and recovery are lower, challenging the notion that it's a riskier financial frontier.

Key Points:

• While investors are quick to discount political risk in emerging markets, their developed market counterparts do not receive the same scrutiny.
• Developed market political risk is just as real as it is in emerging markets and while emerging markets strengthen policy in response to crises, developed markets seem to simply issue more debt and offer lower interest rates.
• Emerging markets corporate debt also looks relatively favorable from the perspective of liquidity, default rates, and recovery values.

Final Thoughts

In a world that is simultaneously worried about endless monetary experimentation and leverage in developed markets, but also looking for attractive yield, EMD has answers. Many emerging markets have strong fundamentals and bonds that pay high yields. DM debt, in many ways, is the opposite, with high leverage and limited compensation. This is why the 60/40 model is being re-evaluated—perhaps rightly so. But even if global debt deserves a lower allocation, we believe EMD deserves to be a bigger part of investors’ overall fixed income allocations.

To learn more about the investment opportunity in emerging market debt, read our full white paper.

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