Local currency emerging market bonds

Emerging market debt is one of the largest, most liquid asset classes in the world. It has an estimated market capitalisation of $11.6 trillion, of which sovereign bonds issued in local currencies account for 72%.*

Investment opportunity

The JP Morgan GBI Emerging Market Global Diversified Index, which tracks local currency sovereign bonds across 19 developing nations, has an average yield to maturity of 6.1%. That’s comfortably higher than the comparative yield of developed market equivalents (see chart below).

Bond yields: Emerging and Developed Markets

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Source: Bloomberg, June 2019

At the same time, the average credit rating of instruments in the index is BBB. This means emerging market debt offers investors both strong relative yield and investment grade credit quality.

The fundamentals of emerging market economies have improved strongly over the past 30 years. In many cases, authorities have tightened regulatory and financial controls and adopted orthodox monetary policies allied to fiscal reform. Fundamentals are further supported by strong demographic changes, including a growing middle class.

By contrast, authorities in advanced economies have spent much of the past decade propping up their markets. Government spending has added enormously to their debt burdens. These countries are suffering from weakening demographics. This will act as a drag on future growth.

It is in emerging markets that investors are more likely to find growth. The International Monetary Fund has forecast that developing economies will increase their share of global gross domestic product to 63% by 2023, based on purchasing power parity.

Despite an attractive yield spread over US Treasuries and low default risk, emerging market bonds remain significantly under-represented in most portfolios.

What drives returns and what are the risks?

The asset class offers an attractive yield, both in absolute terms and in comparison to developed markets. Additionally, currency returns provide a key component of the risk premium that investors look to capture. This return can come with a lower volatility than many would expect. Analysis of historic returns reveals local currency emerging market bonds have experienced an average volatility of 7.3%, compared to 12.8% for global equities**.

Investors in the asset class need to consider the sensitivities of emerging market currencies to economic conditions, commodity prices and debt vulnerabilities. Consideration also needs to be given to specific idiosyncratic country risk.

Diversification benefits

Improvements in economic management have enabled a growing number of emerging market governments to issue bonds in local currencies. This can help to reduce exposure to external shocks. When the MSCI World Index sank more than 50% in the 16 months to February 2009, emerging market bonds provided a positive return of almost 19% (see chart below).**

EMD returns during the financial crisis
Rolling 12-month returns for local currency EMD and global equities

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Bloomberg, June 2019

An appropriate currency hedging strategy can enhance the diversification benefits of the asset class without materially affecting expected returns. This can include funding the purchase of emerging market bonds using a basket of developed market currencies rather than simply hedging all exposures back to base currency.

How to access the asset class

The asset class is highly liquid and can be accessed through a range of open-ended funds and ETFs.

* JP Morgan, 31 December 2018

** This analysis (and all other mentions of returns in this document) uses monthly returns for the JP Morgan GBI EM Global Diversified index against our funding basket from the inception of the index on 31/12/2002 to 30/6/18. For equities we use the MSCI World Index (hedged to GBP) over the same period.

RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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Risk warning

Risk Warning

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.