Key Takeaways:

• Emerging markets have lower debt and higher yields than developed markets, strengthening the case for EMD.
• EMD’s liquidity, default, and recovery rates rival developed markets, challenging risk perceptions.
• EMD remains under-allocated despite strong fundamentals and risk-adjusted returns.

The Investment Case for Emerging Markets Debt

The investment case for emerging markets (EM) debt is compelling and straightforward. EM debt has generated annual returns of 3.68% while developed market (DM) sovereigns returned -0.02%. The past five years look even worse for DM sovereigns. As of now, DM sovereigns’ yield to maturity (YTM) is only 3.6%, while EM sovereigns yield between 5.93% and 6.89% in both local and hard currencies.

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 “fiscal dominance” - excessive debt that undermines central bank independence thus keeping yields too low - EM generally has low levels of government debt that pay higher yields.

Second, these longstanding EM strengths are gaining attention and becoming impossible to ignore with the advent of CNY sharing reserve currency status with the USD (an outcome of the “dollar debasement” trade). EM conducts more trade with China than with the US, so this is important to all EM currencies.

Third, two decades of outright and volatility-adjusted performance shows EM bonds to be too-small an allocation for most investors, and DM bonds to be too-large an allocation.

In “The Investment Case for Emerging Markets Debt,” we discuss why emerging markets have stronger fundamentals than developed markets, why the asset class should be considered now, and its outperformance relative to developed markets.

Topics in this white paper include:

• Why emerging markets have stronger fundamentals than developed markets.
• Why now? The rise of CNY as a Reserve Currency.
• EM Bonds’ superior nominal and volatility-adjusted returns.

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. Fiscal Dominance - 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. Developed markets also grapple with significantly higher debt-to-GDP ratios than emerging markets. Emerging markets 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 6.3% to 7.8%^* and significantly outpacing developed markets. Asia, in particular, has “graduated”: years of orthodoxy pushed nominal borrowing costs down, yet real yields still sit above DM levels, so investors are paid for discipline. 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.

2. Why Now? The Rise of CNY as a Reserve Currency

Central banks have been reducing the share of the US dollar and US treasuries and purchasing gold, and eventually, we believe that other reserve currencies such as CNY will be established. Using the real-effective-exchange-rate (REER) model, CNY screens undervalued by about 15% after a stretch of lower inflation relative to trading partners. Emerging market countries would also benefit as they trade more with China than with the US. Meanwhile, developed markets deal with a “twin deficit” problem (external financing and fiscal financing deficits), which should support emerging market currencies and/or duration. Lastly, emerging market local bonds have exhibited lower volatility than DM in the past few years, as CNY stability has anchored emerging market currencies and thus bond markets.

3. EM bonds Have Superior Nominal and Volatility-Adjusted Returns Than DM Bonds

Our thesis has seen evidence in the form of 150% cumulative outperformance relative to developed-market bonds over the last two decades. Additionally, the efficient frontier for global bonds concluded that the optimal allocation to EM bonds is far higher than most investors maintain. For a U.S. investor targeting a mid-range volatility of around 6.5, the optimal allocation to emerging market bonds would have been about one-quarter of the fixed income portfolio. Across most volatility scenarios, zero allocation to emerging market bonds is the wrong answer.

The Future of Emerging Markets Bonds

“Fiscal dominance” defines developed markets and is driving markets. Its absence in emerging markets points to a key winner in this current market state – emerging market bonds. Low debt and superior fiscal and structural policy in emerging markets have allowed independent central banks that pay high real rates, while collapsing their credit spreads. The opposite and problematic state for developed markets has led to UST’s decreasing use in central bank reserves and growing discussions of USD “debasement”, accelerated by sanctions risks. We think the story about USD/treasuries loss of reserve status is overdone and the wrong framing. But what is correct framing is that CNY and other emerging markets will gradually share reserve status. And China matters arguably more to emerging markets. In fact, we think we are simply observing things well in-train, not speculating. As one can easily observe from two decades of asset performance. The return-to-volatility data points clearly to much higher allocations to emerging market debt.

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

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