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Diversification and yield are some of the reasons why investors access emerging markets debt hard currency. We explore the potential benefits and risks of the asset class.
Institutional investors face the challenge of capturing yield, diversification, and growth from their fixed income allocations. Over time, emerging market (EM) government bonds have provided investors with higher yields and differentiated returns relative to developed markets, showing modest correlation to global equities and global bonds.
This is one of the ways to invest in emerging markets debt (EMD) asset class. Over the past two decades, the universe has grown substantially, encompassing three key investible areas:
The universe based on these sub-asset classes is US$16.8 trillion1. This represents a material portion of fixed income markets. As the HC asset class is driven by the credit risk of lending to the sovereign, it is most comparable in terms of risk factors to corporate credit. Yet, it is also different in that credit risk tends to be overpriced in sovereign EMD HC when comparing the default perception to reality.
Historically, average default rates for the asset class have been 1.03% pa2. Perceived default risk is higher than actual default risk and often defaults are in smaller frontier markets, while the bigger part of EM has become quite resilient over past decades. While defaults and restructurings do happen, unlike with corporate bankruptcies, the country continues to exist and serve its population going forward. Coupled with the greater involvement of institutions such as the International Monetary Fund, this creates wider scope for debt negotiation between the country and its creditors.
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1Source: J.P. Morgan, total debt stock, June 2022.
2Source: J.P. Morgan, 1 January 2003 to 31 August 2022. EMBIG default rate notionally weighted. Note: Although Ukraine is not being treated as a defaulted issuer in the EMBIG, we are factoring it into the rate due to the restructuring, as credit default swaps were triggered.