Emerging markets are raising an increasing amount of debt to fund future growth – including new record amounts being issued to the investing public in 2016.
Total debt issued by emerging markets has risen six-fold since 2008
In fact, the total debt issued by emerging markets has risen by approximately six-fold since the 2008 crisis and only seems to be heading higher.
Whether or not this debt expansion is always sustainable is a subject of further analysis, however before we begin to discuss the underlying peculiarities of this investment choice, we first need to remind ourselves that emerging markets tend to behave very differently to the major western markets, especially during times of distress.
Understanding Risk: Correlations and Volatility
We emphasis risk analysis because it is a very important consideration for emerging market exposure, and needs to be embedded into our longer-term thinking. Therefore, while we believe the greatest way to avoid a permanent loss of capital – our definition of real risk – comes from choosing the best valued assets, we must consider risk in a portfolio context too.
As our valuation-implied calculations have illustrated, this has meant making a choice between negatively correlated assets with poor valuations such as western world fixed income, or opting for positive correlations with positive valuations such as emerging market debt. Neither are ideal, however it is the reality we find ourselves in.
We believe passive management has short-comings for this asset type and active management is a natural choice for investors that want exposure to an attractive asset class whilst avoiding preventable risks. Against this backdrop, we have identified some key considerations when investing in hard currency emerging market debt – or those emerging market bonds denominated in dollars.
Relative Valuation
Versus other fixed income assets, emerging market debt issued in hard currency looks attractive. It sits around historic mid-range from a valuation perspective. Compared to United States corporate spreads it also looks cheaply priced, but analysis shows this to be dominated by extreme Venezuelan spreads, reducing our whole-of-market conviction. Our scenario analysis suggests that in all but the worst examples we would see a positive 10-year real return, although a quick shift in yields would result in short-term losses. The possibility of a United States rate rise causing a faster yield shift than modelled could impact short-term returns, although returns over the longer-term are positive.
Fundamental Risk
As with all fixed income assets, there is a risk from a change in global rates regime. Worst case, this could lead to short-term negative returns, suggesting an element of prudence is desirable. That said, the asset class offers positive real returns under most scenarios, even assuming a return to more normal yields, and thus we see the risks from this asset as reasonably contained.
Contrarian Indicators
Dollar-denominated currency bonds were never really affected by the negative fund flows in the same way as local currency exposure in recent years. Flows have been relatively subdued, but remain positive in general. Investors are only now moving towards overweight positioning across emerging markets. However, short term flows have been very strong, therefore emerging market debt in hard currency is in danger of moving to a low conviction position on this basis.
In summary, we find that despite the falling yields, the continued positive valuation-implied returns and the additional risk analysis warrants continued exposure to this opportunity; in hard currency terms. Local currency debt is significantly more complex and best suited to those with a higher risk tolerance.
