EM Debt: To Hold, or Not to Hold?

Exploring the Debt of Emerging Countries and Companies

March 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Hard currency emerging market debt outperformed local currency EM debt since 2013
  • EM government and corporate debt traded comparably
  • Adding EM debt to a traditional US equity-bond portfolio would have generated only marginal benefits

INTRODUCTION

Forecasting the short-term outlook for the S&P 500 is like predicting the weather in Scotland. The likelihood of getting it right is not particularly high and anything can be expected. However, evaluating the long-term prospects of a stock market seems to be a function of its valuation. It is not a perfect relationship, but the higher the multiple on average, the lower the subsequent return over a 10-year time horizon.

In fixed income, forecasting returns is somewhat easier as the current yield is a significant indicator of the long-term total return. Stated differently, what you see is what you get. Unfortunately for pension funds, insurance companies, and savers in general, bond yields are currently negative or extremely low in most developed markets.

Investors seeking yield, diversification, or both, could look at emerging market (EM) bonds. The consensus is that these offer higher expected returns given more risk than bonds of developed markets, although capital market assumptions vary significantly across financial institutions. JP Morgan expects long-term returns of 5.3% for EM debt, compared with only 1.6% by GMO.

Unfortunately investing in emerging market debt is complicated as it is a complex asset class. Bonds are issued by countries and companies, either in local or hard currency, which is typically in the US dollar. The universe of available instruments includes mutual funds, ETFs, and single bonds. Adventurous investors have provided financing for Mozambique’s fleet of tuna-fishing boats in 2016 and granted Argentina with capital for a century in 2017, shortly after the country emerged from a debt restructuring.

In this short research note, we will contrast emerging market government versus corporate debt and investigate if an allocation would have been accretive for a traditional US equity-bond portfolio in recent years (read Equity vs Bond Indices).