Although risky, the search for yields leads to emerging market debt

The geographically diverse emerging market debt universe is liquid; growing at a rapid pace; and most of all, provides superior returns relative to developed market bonds.

Emerging market debt (EM) has been the solution for higher yields in the current low interest rate developed market environment.

According to research (September 9, 2014) published by Bank of America Merrill Lynch (BOAML) “from January 2001 to today, local currency bonds in the emerging markets generated a cumulative return of 199.3% for an un-hedged investor. This compares to 79.6% invested in US Treasuries over the same period.”

The research adds: “Although the volatility of local debt may seem high at times, the Sharpe ratio for local currency debt for a USD investor was 1.23 compared to 0.5 for US Treasuries.”

Currently, at US$14.5 trillion, the universe of emerging market debt represents approximately 12% of all bonds issued and is relatively liquid and growing at a healthy rate. With more than 60 different countries issuing bonds, investors have exposure to different countries and regions with varying economic conditions – providing wide geographic diversification.

BOAML notes that the total global emerging market (GEM) domestic tradable debt universe increased 8% in 2013 to reach a new high of $14.5 trillion total debt outstanding, while the stock of domestic sovereign debt rose 2.3% to $6.7 trillion in 2013.On average, total GEM domestic debt stock has grown approximately 15% per year since 2000.Brazil, Russia, India and China comprise 58% of all domestic GEM debt; while domestic government debt accounts for approximately 53% of all GEM debt and domestic corporate debt 47%.

Asia has the most local debt market issues, but capital controls make the region less accessible to foreigners. However the Emerging Europe, the Middle East and Africa (EEMEA) region is the most accessible. But Latin America generally offers the highest yields and total returns.

Arguably, in spite of declining yields, EM sovereign and corporate bonds remain attractive. Compared to developed market bonds, both EM high yield and EM investment grade spreads have room to contract and yet provide significantly higher yields.

Emerging countries have also experienced a significant improvement in credit quality, facilitating better ratings on their bonds. Currently over 60% of EM bonds are rated investment grade.

The majority of emerging market debt is issued now in local currency, reducing the probability of default, as evidenced during the 1997 Asian crisis and 1998 Russian ruble crisis. Incidentally, bonds issued in local currency are not susceptible to swings in the US dollar, reducing currency exposure.

There are no systemic risks on the horizon in EMs. Their economic growth remains significantly higher than in developed markets; their debt levels are substantially lower; and they now have much higher foreign reserves.

However, challenges to investing in local debt markets remain, according to BOAML. “Excessive inflow of capital strengthens currencies and interferes with economic policy. Sudden outflows have depressed lending, and triggered domestic financial volatility. In response to that, some policymakers have interfered and imposed measures to discourage such flows.”

As well, “Since the summer of 2013, there have also been heightened concerns about the implications of tapering and rising developed market rates for EM local bond performance. Despite this, we have seen consistent inflows into local markets, picking up even more heavily in 2014. As a result, foreign investors have become a significant portion of the investor base in many local debt markets. This highlights the risk that outflows and foreign exchange hedging may have on prices if sentiment shifts,” states BOAML.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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