The significant growth seen in the emerging market (EM) debt asset class means it accounts for around a third of the global debt market today. This alone means asset allocators should give it careful consideration. In addition to its impressive growth, the evolution of the asset class over the past decade has been remarkable. While this has created a broader opportunity set, it has also increased the complexities around investing in it. Here we take stock of the asset class today, outline how each component has evolved, and explain the implications for investors.
Hard currency sovereign | Hard currency corporate | Local currency sovereign | |
---|---|---|---|
Definition | Debt issued by EM governments and companies that are 100% state-owned. Denominated in US dollars (or, e.g., euros). | Debt issued by companies based in emerging market economies, usually denominated in US dollars (or, e.g., euros). | Debt issued by EM governments that is denominated in the domestic currency of the issuer. |
Index* | JP Morgan EMBI | JP Morgan CEMBI | JP Morgan GBI-EM |
Index launch | 1993 | 2008 | 2003 |
Market cap. (US$bn) |
1,270 | 1,100 | 4,840 |
Countries | 72 | 63 | 20 |
Issuers | 162 | 748 | 20 |
Yield, % | 7.9 | 6.6 | 6.4 |
Duration | 6.5 | 4.1 | 5.3 |
Average credit rating | BB+ | BBB- | BBB+ |
Source: Ninety One, JP Morgan EMBI Monitor, as at 31 December 2024. *The indices shown are those that are most commonly adopted as a primary benchmark by investment managers, however, other indices representing the investable universe exist, such as those provided by Bloomberg and ICE.
The EM debt asset class was born in 1989, with the creation of ‘Brady bonds’ by then US Treasury Secretary Nicholas Brady. The debt-reduction plan enabled commercial banks to exchange their claims on developing market governments (mainly from Latin America) and convert them to more tradeable and liquid Brady bonds. Since then, hard currency debt markets have become an increasingly important source of financing for emerging markets and remain the main entry point for most countries when making their first foray into global fixed income markets.
Compared to the early 1990s, when four countries (Argentina, Brazil, Mexico and Russia) accounted for over 80% of the market, the size, complexity and diversity of the flagship EM hard currency debt index – known as the JP Morgan Emerging Market Bond Index (EMBI) – has changed hugely, and it now encompasses 72 countries.
Over the past 10 years, a diverse array of countries have joined the EMBI, making it a truly global investment universe. For example, the inclusion of the Gulf Cooperation Council (GCC) region1 in the EMBI since 2019 has meant that the regional weighting of the Middle East has quadrupled to around 20%. This has coincided with the growth of Islamic finance in the form of sukuk debt2 as a valuable financing alternative to traditional bonds.
The index has also grown through issuance from an increasing number of smaller ‘frontier’ markets, including countries in central Asia and Sub-Saharan Africa. Frontier markets today account for approximately a quarter of the EMBI constituents3 with this globally diverse opportunity set doubling in the past 10 years.
Over the last decade the average credit quality of the universe has remained steady despite significant global turbulence caused by the COVID-19 pandemic, Russia’s invasion of Ukraine, and recent inflation shock. The growth of frontier markets has led to a rise in the number of high-yield constituents within the EMBI, but the inclusion of more countries from the GCC region, which tend to be of higher credit quality, has counterbalanced this. The result is a greater dispersion of return outcomes, especially relating to the potential for rating upgrades, which creates a rich hunting ground for active investors.
Credit rating evolution of the EM HC sovereign bond universe, % of universe
Source: JP Morgan EMBI, as at 30 November 2024.
Looking ahead, fundamental improvements in emerging markets are fueling an improvement in rating dynamics. Combining the credit rating outlooks of S&P, Moody’s, and Fitch, at the time of writing we find that 39 emerging markets are on positive outlook, compared with 20 that have a negative outlook.
EM corporate debt is a relatively new asset class, but rapid growth means it is now double the size of the US high-yield market. It has transformed into a valuable portfolio allocation for an increasing number of investors. Over the past 10-15 years, the market has become a lot more diversified — it now gives investors access to a broad range of opportunities, spanning sectors, credit ratings, and all regions globally.
It is an often-overlooked fact that emerging markets are home to many market-leading companies, with a global footprint and geographically diverse revenue sources. And while Asia’s increased share of the market has seen the investment-grade rated part of the market grow, across the investment universe, underlying fundamental strength is often underappreciated by market participants. EM country-specific concerns often overshadow otherwise solid company fundamentals, pushing yields higher than those offered by developed market (DM) bonds of a similar credit quality. We describe this as a ‘post-code premium’ and it translates into an attractive risk-reward profile for investors who are willing and able to carefully analyse the issuing companies’ fundamentals.
EM companies typically have very low leverage, and shorter maturity profiles. This is due to EM corporate debt being a relatively new asset class (compared to developed market debt) and having less frequent issuance needs, which has the beneficial effect of forcing companies to maintain a culture of retaining cash whilst containing leverage. This has been particularly evident since the COVID-19 crisis, as many companies have pared back their expansion and capital expenditure, leaving them with healthy cash balances and strong buffers.
Today, the fundamentals of the EM credit opportunity set compare very favourably with developed credit markets.
In just over 20 years, the EM debt local currency debt market has grown to become the dominant segment of the overall EM debt asset class today. The composition of the main index (JP Morgan GBI-EM) has also evolved, with significant changes including the addition of China in 2020 and the exclusion of Russia in 2022. More recently, India’s inclusion in the index in 2024 underscores the quality, depth and liquidity of the asset class.
Crucially for active investors, while the index remains relatively concentrated (comprising 20 countries), the investable universe has expanded dramatically to include 714 local markets, with frontier debt representing much of that growth. With characteristics such as high yields and low correlations to global markets, frontier local currency debt offers compelling off-benchmark opportunities to investors with the technical ability and research resources to exploit the full market. The asset class has evolved to be one of huge breadth, offering high quality and liquidity while still providing an attractive yield pick up to developed market bonds.
Despite the fundamental improvements seen in this increasingly diverse (and diversifying) opportunity set, local currency debt remains an under-owned asset class in investor portfolios, with foreign ownership of local currency bonds in particular standing at just 14.9% (from a high of 24.2% in November 2014)5. The gap left by this fall in international demand has been filled by domestic investors in emerging markets. This bodes well for current and potential investors, as lower foreign ownership tends to mean that in times of market stress there is less forced selling and the (increased) local investor base typically acts countercyclically - with local investors more inclined to hold onto their assets through any bouts of market turmoil.
An understanding of the investor base is crucial to successful investing in EM local debt markets. While flows data typically focus on offshore investors, it’s interesting to look at who the real long-term investors are. EM debt has a very broad investor base and local investors – banks, assurance and insurance, as well as local pension markets – are very important for the asset class. That means local regulation is also an important driver, not only of holdings, but also of prices. For this reason, an understanding of the local backdrop is of paramount importance to understanding the fixed income market and yield curve. Local investors are the key holders of local debt in markets such as South Africa, Mexico and Brazil; the reasons behind this are varied and often country specific. Local holders are also a big consideration in corporate markets – given the low level of onshore local currency corporate bond investment by offshore investors – this market is dominated by local banks and insurers, who typically have very long investment horizons.
In all parts of the market, a maturing of the asset class has created a diverse range of investment opportunities across the credit rating spectrum, and the associated increased dispersion of return outcomes is an ideal backdrop for active investors.
The hard currency debt market today is highly diverse, spanning oil exporters and importers, regional manufacturing hubs and services-driven economies across the globe. The increased importance of frontier markets also offers the opportunity for investors to take meaningful – and diversified – exposure to a broad range of underlying return drivers. These smaller and often less liquid markets are typically under-researched by the mainstream investment community and rife with information asymmetries, bringing greater potential for alpha capture to those willing and able to do the necessary analysis. For instance, investors can seek to benefit from rating upgrade stories among reforming economies, and alpha opportunities also exist around IMF programmes for asset managers able to see beyond the (often negatively skewed) headlines. Crucially, the conviction to stay away from more vulnerable markets is vital in this investment universe.
EM debt, spanning, hard and local currency assets and incorporating sovereign and corporate risk, makes for a varied and diverse investment universe. For instance, within the EM hard currency debt market (JP Morgan EMBI) El Salvador has delivered an annualised return of 12.5% over the past five years, compared with Lebanon’s -22%. Significant return dispersion is also evident within individual countries – for example, Argentina’s best annual return over the last five years was 103.1% in 2024; its worst was -23.8% in 2020. This highlights the importance of choosing carefully when to invest, and when not to. The same conclusion can be drawn from local currency bond markets (JP Morgan GBI-EM) where monetary policy regimes can vary significantly: the Dominican Republic’s local currency bonds have delivered five-year annualised returns of 8.6%, compared with Turkey’s -24.2%. And despite the weakness seen in Turkey over a five-year period, in 2022 the country’s local bonds return 23.8%. The key takeaway is that this is a diverse universe, where the opportunity for alpha generation is high.
The corporate credit market now dwarfs the US high-yield market and provides access to some world-leading companies. The fast-growing and increasingly diverse asset class compares very favourably to developed markets; with higher yields, lower duration and less leverage than US debt for comparable credit quality, it can provide a high-grade complementary solution for institutional investors. In addition, the tendency for sovereign dynamics to overshadow fundamentals creates market dislocations that active investors can seek to exploit.
In a world in search of diversification, the EM local currency debt market’s low correlation to global markets is an attractive characteristic. The differentiated behaviour of local currency debt portfolios, especially for non-US dollar based investors, reflects the distinctive factors driving returns: differing interest rate regimes, divergent economic cycles and currency fluctuations. Furthermore, the diverse drivers of the local currency debt market make it an inefficient market that offers plenty of alpha-capture opportunities across various avenues – from hedging FX exposure to take advantage of monetary policy cutting cycles and reduce FX risk, to yield-curve positioning strategies as inflation cycles adjust to proactive monetary policy. Frontier markets here also offer significant (off-benchmark) opportunities – exhibiting characteristics such as high yields and low correlation to global markets.
In summary, the heterogenous nature of the asset class – in terms of the wide range of underlying credit quality, regional disparity, and unique idiosyncratic drivers – differentiates it from other fixed income markets, presenting opportunities investors should not overlook. While the wide range of return outcomes seen across and within parts of the EM fixed income universe make this a complex market to invest in and necessitates a careful approach to risk management, the potential reward is significant for investors with the necessary expertise and local knowledge.
1 Comprises Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.
2 A sukuk is an Islamic financial certificate, similar to a bond, that complies with Islamic religious law.
3 Countries that are typically marked by lower credit ratings and higher spreads than traditional emerging markets.
4 JP Morgan, November 2024. Number of countries with investable local currency market (either FX or bonds).
5 JP Morgan, mid-2024 data.
General risks. The value of investments, and any income generated from them, can fall as well as rise. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss.