Emerging market debt: down but not out

It would be an understatement to say the last six months have been difficult for emerging markets (EMs).

From the Chinese homebuilder crisis to Russia’s invasion of Ukraine, a concatenation of events has made investors wary of emerging market debt (EMD). As inflation has soared, global fixed-income assets haven’t offered portfolios much protection. However, in this negative or low-return environment, we believe that short-duration EMD could offer an opportunity for positive returns.

Due to liquidations and outflows, we now see an opportunity at the shorter end, with yields now higher than an all-duration benchmark.

The yield on a benchmark of blended EM short-duration corporate and sovereign debt is approaching 7%, which translates to carry of around 60 basis points per month (versus an all-duration benchmark) and could potentially provide a cushion against negative price returns.

Don't believe the hype

In the year to date, emerging market short-duration debt (as represented by the JP Morgan 50% EMBI Global Diversified and 50% CEMBI Broad Diversified Index) reduced in value by -9.4%, albeit outperforming global investment-grade corporates (which fell over 10% during the same period) and global high yield (which fell over 10%), and slightly underperforming US Treasuries, which have returned -8.5%, as you can see below:

Source: Bloomberg as at 5^th May 2022. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.

In a nutshell, we believe that the debate about whether rising interest rates will be sufficient to curb the global surge in inflation has superseded geopolitical risk. The latter has historically led to a rally in government bond yields which hasn’t materialised this time around – meaning that so far in 2022, there has been no place to hide for fixed income investors.

What next?

The repricing of the risk premiums associated with emerging markets has led to valuations reaching what we believe is an attractive entry point for investors worried about the relentless rise in interest rates in developed markets (DMs).

The following tables simulate the spread and US Treasury yield shocks and resulting total returns in 12 months’ time for the JPM EM 3-5 years Sovereign Index (EMBI GD) and the JPM EM 3-5 years Corporate Index (CEMBI BD).

From current levels (US 3-year Treasuries at 2.90%, and EMBIG and CEMBI spreads at 510bps and 350bps respectively), our research indicates that absolute yields would need to rise by a significant margin to fully offset the carry generated by the bonds over the next 12 months.

The first scenario models this through an increase in EMD credit spreads by 200bps, while the second scenario models a combination of a material increase in US 3-Y Treasury yields and the widening of credit spreads , as you can see:

Source: Bloomberg as at 5^th May 2022. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.

Scenario two is in effect a continuation of the trends that characterised the first quarter of 2022, where the fixed income sell off-continues, leading to a potential situation where we think EM credit could continue to outperform the DM markets, cushioned by the carry.

Scenario one, however, depicts the blowing up of credit risk in a narrative similar to the early days of the COVID-19 pandemic. Credit selection and diversification would be key to managing such a scenario. At the same time, the outlook for commodities is probably better than that for global growth, which could support EM debt.

What could go wrong?

Quantitative analysis based on historical data is useful, but it is impossible for it to capture all the risks associated with investing in any asset class. This is particularly true for EMD, which is more exposed to country-specific risks.

That said, we believe EMD offers an opportunity for diversification, as most indices provide exposure to many more countries than typical DM indices. For example, an index comprising of 50% of JPM EM 3-5 years Sovereign Index (EMBI GD) and 50% of the JPM EM 3-5 years Corporate Index (CEMBI BD) would provide exposure to 67 countries, along with 399 investment-grade and high-yield corporate issuers. The single largest country exposure is China, consisting of more than 100 issuers and representing 7.3% of the index.

By comparison, the Bloomberg Barclays Global Aggregate Corporate Index provides exposure to 62 countries, but the single largest country exposure is the USA, representing 52% of the index.

We believe that the diversification opportunities and the current level of yield provided by EM short duration indices provide an interesting case for the asset class for fixed income investors looking for additional income and less exposure to interest rates.

However, investors must mindful that the asset class still carries significant risks and any investment decisions must only be made after careful analysis and consideration.

Unless otherwise stated, data are based on LGIM analysis as at 13 May 2022

Past performance is not a guide to the future. 

The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. It should be noted that diversification is no guarantee against a loss in a declining market.

For illustrative purposes only. The above information does not constitute a recommendation to buy or sell any security.