Revisiting EM Hard Currency Debt

The fast view

• Investors are increasingly reassessing their allocation to emerging market (EM) hard currency debt, one of the few remaining sources of yield in today’s global fixed income markets. In addition to yield, the risk-adjusted return profile and diversification properties of the asset class explain why some institutional investors’ capital market assumptions are pointing toward larger allocations.
• Although investors have flocked to developed market (DM) credit for yield pick-up, superior fundamentals for comparative credit quality mean EM hard currency debt may improve the yield and return potential of portfolios without introducing excessive risk. Over the past decade, EM fundamentals have strengthened, reinforcing this benefit.
• The remarkable evolution of the asset class over the past decade has seen the number of markets almost double (now 73) and its regional footprint diversify significantly. The increased importance of smaller, less-liquid high-yield markets has broadened the opportunity set, while introducing new challenges and complexities.
• The size, diversity and liquidity considerations in the investment universe today make a high-conviction, selective approach essential. At the same time, investors need to be careful to avoid a concentration of portfolio risk, given the potential for negative credit events to erode returns.
• In the COVID era, the importance of structural reforms in EM has risen; investors should look for managers with the depth and breadth of expertise to identify early those economies that are on the right path and, conversely, those where a structural deterioration is occurring and credit sustainability is under question.
• The ‘G’ in ESG has always been critical in EM. However, the ‘E’ and the ‘S’ are becoming increasingly important to integrate, introducing additional challenges given the inherent complexity of ESG analysis among EM.
• With the continued scarcity of yield in fixed income markets, we expect more investors to revisit their EM hard currency debt allocations. Other supportive tailwinds for the asset class include improving trade flows within EM, and we continue to see attractive valuations in high-yield markets where spreads are yet to fully recover.

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