Too big to ignore? Unlocking the potential of EM debt

In this article, we will look at the evolution of the Emerging Markets Debt Hard Currency (EMDHC) asset class, dispel some common misperceptions of this asset class and explain the importance of understanding sovereign credit risk expectations as a core component of market movements. Further, we will outline why asset owners should consider an allocation to this evolving universe, and the potential for bottom-up active investment management to add value in this space.

First, let us define what we mean by EMDHC. These are bonds issued by emerging market governments, including quasi-sovereigns, denominated in hard currency – typically US dollars or euros. The hard currency aspect means there is no direct exposure to fluctuations in local EM currencies.

Most investors in this asset class also have opportunities to invest in government majority-owned EM corporates and pure corporates. At Janus Henderson, our EMDHC focus is primarily on sovereign and sovereign-related risk. The performance benchmark many investors use for this asset class is the JP Morgan Emerging Markets Bond Index Global Diversified (EMBIGD).¹

The evolution of the asset class

Since we first started investing in this asset class as a team in 2013, we have seen a significant increase in the number of countries in our universe – from 56 to 70 today. From the early evolution of the asset class in the early 1990s, the increase relative to today is even more dramatic: from 14 countries to the current 70.²

This makes EMDHC one of the broadest asset classes in terms of country exposure globally. Collectively, these countries constitute approximately 80% of the world’s population and are a major driver of global economic activity. These countries, collectively, drive more than two-thirds of global growth and account for more than 40% of GDP globally, measured in US dollar terms. Adjusted for differences in purchasing power, the share of global GDP is around 60%.

Simply put, this asset class is continuing to grow and evolve, and is now too big to ignore. Another important point to make is that this asset class needs to be viewed not as one “Emerging Market”, but rather as a very diverse grouping of countries that happen to share a common descriptor.

Perceptions around Emerging Markets (EM) have undoubtedly been distorted by a string of EM crises in the 1990s and early 2000s, but these misperceptions can largely be dispelled by looking at what has happened in EM more recently.

Why consider EM debt hard currency?

Below, we outline various reasons asset owners and their advisers should consider an allocation to this asset class.

Size. This asset class, in aggregate, is almost twice the size of the US high yield market.³ In terms of individual issuance size, most EM government bonds and quasi government bonds are relatively large. In the aforementioned JP Morgan EMBIGD benchmark, issuance size is US$500 million and above, and there are plenty of US$1 billion-plus issuances.

Fundamental diversification. As an asset class driven by macroeconomic fundamentals and global risk sentiment, EMDHC offers significant fundamental diversification in terms of global economic exposure. Around half of the countries in our universe are commodity importers and the other half are commodity exporters. Countries in our universe range from the high growth, very commodity dependent all the way to more innovative, service sector driven economies.

You really have a plethora of very different economic development levels, many different policy frameworks and many different structural characteristics for each and every economy. The asset class offers access to everything from the fastest growing frontier names in sub-Saharan Africa to some of the more diversified middle-income and higher middle-income countries in the world. That means that when you have shocks you will typically have winners and losers, not just losers, providing a degree of resilience at the aggregate level.

Absence of FX risk. This asset class affords access to a diverse opportunity set of fast-growing economies without introducing FX risk, which is something that typically dominates returns when you look at asset classes such as EM equities and EM local currency debt.

Benchmark diversification. Within the suite of diversified EMBI indices that we look at there are no country weights that are much higher than 5%. For example, as of 30 April 2024, China’s weight is below 4% – nowhere near as dominant as in EM equity and EM local currency debt benchmarks.⁴

In essence, these are indices that do not have a few countries dominating and skewing the opportunity set. Rather, every single country matters a little. And in terms of credit ratings, you have a similar picture: a spread of lower rated names – such as those in Sub-Saharan Africa – to a lot of higher rated names, like the UAE and other countries in the Middle East.

Substantial investment grade component. One of the misperceptions around our asset class – because it has the word “emerging” in it – relates to credit quality. Figure 1 shows the ratings split between investment grade (IG) and high yield (HY). As you can see, approximately 50% of the benchmark is IG. Of course, there was a significant improvement in that share during the high-growth globalisation years, with China entering the world economy from around 2001 onwards. Since the global financial crisis, the IG component has been pretty stable.

Improving macroeconomic policy frameworks. Policy quality in EM is generally underestimated by investors and EM fundamentals are often not nearly as bad as some headlines might suggest. In short, there has been a marked improvement in policy frameworks, more than most people recognise. Most importantly, since the 1990s, we have seen a transition towards flexible exchange rates and a move towards more independent central banks with inflation targets – similar economic policy frameworks as seen in most developed economies. There has also been a buildup of FX reserves in many EM countries, providing a credibility buffer for existing floating exchange rate regimes.

Market participants seem to be starting to appreciate the more robust macroeconomic policies in most EMs that have enabled them, by and large, to better weather the macro shocks of the past decade (especially the COVID years). You will always have a few odd cases that will attract a lot of attention. Turkey used to be one of them. Argentina is always one of them. However, most EM countries have actually weathered inflationary shocks quite well, and that is a testament to policy changes that have allowed them to let their exchange rates float and even allowed them to start cutting interest rates ahead of the US Federal Reserve (Fed).

Access to alternative funding sources. Unlike corporates, sovereigns always continue to function even if they end up in some sort of distress and are unable to finance themselves via external public debt issuance. (A case in point being various sub-Saharan African countries that survived despite external debt markets being effectively closed to them for more than a year.)

EM sovereigns have access to alternative sources of financing via the IMF and other multilateral lenders as well as their ability to tax the domestic economy. Unlike corporates that might need to take steps to improve their credit metrics before they can regain market access, EM countries that find themselves in distress can get front-loaded liquidity and financing, typically in return for promising to improve some of their policies. Currently, roughly half of the high yield countries in our universe are in IMF programmes that include conditionalities around fiscal consolidation, certain structural reforms, and so on.

EMs have already gone through a default cycle. We are now in a particularly interesting point in time in EM, not least in view of the painful adjustments we have seen in recent years, with a number of high yield countries having turned to the IMF for assistance. In EMs, we have already had a default cycle of sorts and we do not foresee new defaults around the corner. In fact, we are now seeing EM countries recovering and several sovereign restructurings being wrapped up or in very advanced stages.

Clearly, the current high cost of capital means we will see winners and losers in our space – as always. But we are also seeing some signs of normalisation in that some of the countries that have been under stress in recent years due to high inflation and tight financial conditions, and countries that have been pushed towards the IMF, are slowly coming back to the market.

This recovery/normalisation stands in contrast to the US cycle, where debate is ongoing as to whether the economy is late-cycle or mid-cycle. Whatever the case, we believe EMs are ahead in the cycle compared to the US, and that presents some opportunities.

A thing to note is that historically, emerging markets sovereigns have exhibited a lower capital weighted default rate than corporates on a rating-adjusted basis. In addition, the average recovery rate has been higher, reflecting that, unlike corporates, sovereigns cannot just liquidate and run away from their debts. On the contrary, governments need to preserve a good relationship with bondholders because it can have devastating economic consequences for a country to be shut out from financial markets. Argentina, which did not have access to financial markets from 2002 to 2015, is a glaring example of this.

Superior economic growth. A typically good indicator of how EMs will do versus the US is to look at their respective economic growth rates. When growth in EMs is much higher than in the US, it usually indicates that fundamentals are improving. And provided US growth is not too high, it also means that financial conditions are not simultaneously tightening a lot. That is typically the best environment for EMs – a US economy that is not too hot or too cold.

If you look at the period since the global financial crisis, we have basically had almost a continuous decline in the EM/US growth differential (with an interruption in 2016—17) and then again in recent years, with the US economy remaining more resilient than most people expected. Upside surprises to US growth recently have weighed a little on the EM/US growth differential forecast for 2024. Nonetheless, the EM/US growth differential is expected to pick up in the years ahead and stay elevated. Figure 2 shows IMF forecasts of the EM/US growth differential.

Clearly, one of the challenges going forward for all economies is that we are in a more indebted world. Within the EM universe, for example, some countries are still struggling with the aftermath of COVID-related spending. However, relative to the developed world (the US now spends approximately the same as the entire market cap of JP Morgan EMBI on interest costs every year, which is arguably not sustainable), EM debt metrics have begun to normalise. In aggregate, EM fiscal deficits are close to historical average again in EMBI-weighted terms. With ongoing fiscal consolidation in EM and advantageous structural factors such as better demographics, the EM/US growth differential rate post 2024 is likely to widen.

Overall credit quality improving. If you look at Figure 3, you can see a historical evolution of ratings upgrades and downgrades (excluding CCC-rated bonds). If you look at the last 4-5 years, what we’ve seen is a very negative adjustment during COVID. In 2023, however, there has been an improvement, with more upgrades than downgrades. So, having seen some recovery and stabilisation in EM, we are now seeing an improvement in the overall credit quality.⁵

The asset class has a “credit anchor”

EMDHC is a risky asset class and, as such, is subject in the near term to whatever drives global financial markets; be it EM specific shocks or non-EM specific shocks. Over the longer term, however, the asset class has a “credit anchor” that effectively limits the magnitude and longevity of drawdowns.

Let us explain this in more detail. In the short term, the asset class is hostage to near-term noise, making it difficult to navigate on a tactical basis. Thus, many investors see EMDHC as a strategic allocation.

Some of the near-term noise does impact fundamentals; some does not. What is important to understand is that if you believe in the underlying fundamentals, they are going to determine your investment outcome in the medium-to-long term.

Expressed differently, if you believe that the near-term noise does not significantly impact the willingness and ability of a country to service its debt, then what you effectively have is a “credit anchor” at the country level that eventually pulls down the “noisy” element of the risk premium (Figure 4).

Typically, what happens is that as countries continue to pay their coupons and the noisy global shocks dissipate over time, perceptions of market risk move back closer in line with underlying sovereign credit fundamentals. These periods of mis-pricings present opportunities for active investors with a solid understanding of credit fundamentals.

Most of the shocks we have seen since the global financial crisis have been relatively short lived and without a lot of fundamental impact. The exception, of course, was COVID. Although relatively short-lived, COVID had a fundamental impact because fiscals and debt were significantly impacted, both in EM and developed markets (DM). Most often though, the shocks we’ve seen have been sufficiently short-lived to not have a credit relevant impact and interfere with the financing cycle of countries.

How we think about credit risk – and active management

What we find empirically is that there is a systematic relationship between official credit ratings and market behaviour (implied market rating) over time, with the implied market rating leading (i.e., anticipating) official ratings by 1-2 years.

Via active management, we believe there is an opportunity to capitalise on market overshoots and undershoots of this historically systematic relationship to generate alpha.

Figure 5 is a simple chart showing this systematic relationship, using Brazil as an example. The dark line is the official average credit rating for Brazil and the orange line is how the market is pricing credit risk in Brazil relative to other EM countries, which we call an implied market rating (IMR).

Market pricing is clearly forward looking and is driven by expectations about ratings 1-2 years into the future. Interestingly, we see clear signs of behavioural inefficiencies in our market when ratings change direction.  If a ratings story changes from being positive to neutral or negative to neutral, historically we have observed mis-pricings of around 1-2 notches in the upgrade stories and 2-3 notches in a downgrade process. It takes the market some time to figure out whether a rating story that is no longer positive is now neutral, or whether a rating story that is no longer negative is now neutral. This behaviour is also suggestive of herding or confirmation bias where investors look for information that confirms the past good or bad ratings trajectory.

What we do at Janus Henderson, based on our proprietary sovereign credit research framework, is to figure out where ratings are moving in the next 1 to 2 years, because that is what is going to anchor credit risk premia at the country level. This is a different school of investing as it focuses more on the trend-like behaviour of sovereign credit risk than the short-term fluctuations. Reducing the analytical frequency needed to process and assess sovereign credit risk has been important for us as a relatively nimble team.

Without going into detail about how we analyse sovereign credit risk, what is clear to us is that a slow-moving core component of credit risk exists, which we believe can be predicted. Central to this core feature – and sovereign credit risk itself – is governance. And highly correlated to the two different measures of governance that influence sovereign credit risk is, of course, the quality of economic policy and reform policies in general. Identifying what kind of policies will influence the market perception of sovereign credit risk and to what extent, is an essential part of our fundamental analysis.

Labelled bonds a small but growing universe

Labelled bonds are still a small component of the overall asset class, but it is growing (Figure 6).  These bonds allow investors to target certain activities in the sustainability area.

To get a better sense of the purpose of labelled bonds, let us look at two recent issuances as examples. The first is Benin, which issued a €500 million Sustainable Development Goals (SDG) bond whose proceeds have been earmarked to four sustainability pillars: Population (agrobusiness and access to drinking water); Prosperity (improving access to low-carbon energy sources); Planet (biodiversity conservation and reforestation); and Peace (preservation of heritage sites). The second example is Uruguay, which issued a Paris-aligned US$1.5bn sovereign sustainability-linked bond (SLB). In this case, the coupon is directly linked to two Key Performance Indicators (KPIs). The first KPI is decreasing the country’s carbon intensity per unit of GDP. The second is protection of native forested areas.

At Janus Henderson, analysing ESG relevant factors has always been an integral part of our investment process. That notwithstanding, with the nascent growth of labelled bonds, it is becoming a bit easier to target investments specifically designed around specific ESG objectives.

Return expectations

The intersection of the X and Y axes highlighted in bold in Figure 7 gives you a sense of near-term return expectations. It is a very simple table that allows you to play around with the two factors that will determine your total return – spread and underlying US treasury yield.  It shows the expected 1-year total return at a benchmark level as of 29 April 2024 (7.3%), and what happens to this return given a move in the underlying US Treasury yield, with the other axis constant, or what the total return might be given a change in the sovereign spread, with the Treasury yield remaining unchanged.

An important point to make here is that over the last couple of years, a significant increase in US Treasury yields has coinciding with a significant increase in sovereign spreads. So, you had a positive correlation between the two because the shock was inflation.

Looking ahead, if you believe we are now transitioning into a more normal kind of economic cycle that is more growth focused than inflation focused – which is more normal – we would expect the correlation between Treasury yields and sovereign spreads to turn more negative. Of course, we also still need to see inflation continuing to come down. Overall, though, we believe there is now a bit more protection in the asset class from an overall higher yield and from a Treasury yield that has now priced in quite a lot of inflation.

Past performance is no guide to the future, but it may be of some comfort to highlight to asset owners who may be considering a strategic allocation to EMDHC that the asset class has a strong performance track record. Since the early 1990s, EMDHC has had one of the highest risk-adjusted returns among public fixed income asset classes.⁶

Final thoughts

The evolving EMDHC asset class represents a useful diversifying component to a broad-based portfolio – not only in terms of the breadth of underlying economic exposures and their growing significance to the global economy, but also in terms of their asynchronous position in the economic cycle relative to many developed countries. Further, the changing threats and opportunities for economies all over the globe (arising, inter alia, from a fragmented geopolitical environment and the gradual shift towards a more multi-polar world), calls, we believe, for diversified investments – and EMDHC is a very diversifying asset class.

Some parts of the EMDHC universe are still emerging from the inflation shocks that hit the global economy over the past couple of years. We are still working through some of the overhang from the policies implemented back in the COVID years and, more recently, the inflationary shock from the Russia-Ukraine war. The positive takeaway is that fiscal consolidation is taking place, credit quality is gradually improving at the aggregate level, and the EM-DM economic growth rate differential – an important element of the outlook for EMDHC – is set to move higher in favour of EM.

Sentiment on this asset is often dominated by news headlines (often negative) and there is a tendency to view exotic events in one or two countries (e.g., monetary policy decisions in Turkey) as typical of the whole. From our perspective, there are many good things happening in the asset class. Over the medium term, better policies are typically underestimated, and fundamentals are usually not as bad as some headlines suggest.

Over time, it is fundamental sovereign credit risk that counts. Near-term market noise will sometimes produce spikes in sovereign spreads, but spreads will soon re-anchor themselves lower in approximation with sovereign credit risk fundamentals, dampening the extent and duration of drawdowns in the asset class, except in less frequent cases where the shock has a more fundamental impact on a country.

This is an asset class that readily lends itself to active management. Markets moves have a systematic relationship to anticipated moves in credit quality but tend to overshoot on both the upside and downside. Active managers undertaking fundamental research can potentially deliver alpha by correctly identifying key points at which markets misprice anticipated moves in sovereign credit risk.

In terms of near-term performance, our view is that 2024 will continue to see attractive risk-adjusted returns. Clearly, spreads have tightened, leaving less room for additional tightening, but overall yields remain high in a historical perspective, presenting an opportunity in an asset class that is fundamentally improving. Further, with policy rates in key western developed markets likely having peaked, this represents a positive for the asset class as, historically, the two years following a pivot in the rate cycle in the US have been positive for EMDHC returns. In our view, attractive yields/carry offer a buffer against spread widening and will likely constitute the lion’s share of the attractive total returns we envisage for 2024.