Emerging market debt (EMD) is often considered a homogenous block, but within this seemingly uniform landscape lies a very large opportunity set. Understanding the nuances within the hard and local currency segments of the EMD universe are as crucial as navigating with a selective country-by-country approach as volatility and uncertainty persist.
EM bonds, a strategic holding for many investors, come into two broad categories: EM hard currency bonds and local currency-denominated bonds.
Hard currency bonds, essentially a credit asset, typically offer a yield pick-up over US Treasuries (in the case of US dollar bonds), compensating for taking on additional risk. This yield spread is influenced by changes in the credit profile of the issuer and by global fluctuations in risk appetite.
On the other hand, local currency bond returns hinge on changes in domestic interest rates and shifts in the shape of the yield curve, with less emphasis on creditworthiness changes. These bonds are closely tied to their countries’ fiscal, monetary and macroeconomic policies, offering a risk-reward trade-off for investors seeking currency diversification. And as sovereign borrowers build their local currency bond yield curves, duration and curve positioning increasingly become important sources of return.
Differences in emerging market debt composition
Hard currency debt provides exposure to a broader range of sovereign credits but often with higher credit risk. The EMBI Global Diversified Index contains sovereign issuers from 69 countries, with lower-rated, export-dependent nations dominating the index. In contrast, local currency bonds as represented by the GBI-EM Global Diversified Index contain sovereign issuers from 20 countries and beyond that can offer a more diverse range of fixed income instruments, including inflation-linked bonds and derivatives.
The average credit rating of emerging market sovereign dollar bonds in the EMBI Global Diversified Index is BB+, compared to BBB+ for emerging market bonds issued in local currency in the GBI-EM Global Diversified Index.
A hard-currency-only emerging market bond mandate is generally more exposed to the debt of commodity-producing nations and to countries whose prospects are tied to swings in global economic conditions.
Whilst local currency markets currently offer limited corporate bond exposure, we would expect this to grow in future. Small issue size, unfavourable withholding tax treatment, poor custody arrangements, legal restrictions, and capital controls have provided headwinds to the development of a local corporate bond market in some emerging markets.
In contrast, the US dollar–denominated corporate bond market offers diverse investment opportunities — many of which are unavailable to equity investors. Most of this debt is investment grade, reflecting marked improvements in the way emerging market corporations manage their balance sheets.
While hard currency bond markets offer better access to corporate credit, local currency markets provide a variety of fixed income instruments and alternative hedging tools: nominal bonds, inflation-linked bonds and derivatives, currency-linked debt, GDP-linked warrants and money market instruments.
Putting that all together, local bond markets exhibit greater depth and growth potential, with a market capitalisation of over US$3.41 trillion, more than three times that of the hard currency markets. The ability to buy and sell assets without causing unfavourable price shifts, or liquidity, is a significant advantage for local bond markets.
EM debt in the current economic environment
Despite recent challenges—such as the Federal Reserve’s decisions, China’s unexpected stimulus outcomes, and geopolitical concerns—EMD holds promise due to several factors:
First, fundamentals remain strong. Fiscal deficits have narrowed, current accounts – a measure of foreign trade activity – are on a long-term improving trend, and global factors such as US rates, risk sentiment, global growth and inflation are likely to continue driving emerging market debt over the next few months. Macroeconomic fundamentals in the major EM countries, combined with high starting yields, undervalued exchange rates and more stable commodity prices should provide a buffer against volatility.
Second, there are improving inflation dynamics. EMs’ earlier consolidation efforts have contributed to lower inflation in many emerging markets. Including Brazil, Chile and Hungary, providing central banks the room to start easing policy rates. This, coupled with moderate economic growth, should be positive for local currency debt.
And then there is the potential shift in Fed policy. The US Federal Reserve’s cautious approach, despite high inflation, hints at a potential end to its hiking cycle. If inflation continues to fall, the Fed has signalled it will begin cutting rates, strengthening other currencies against the dollar, and benefiting EM countries.
Valuation opportunities
Opportunities within the dollar-denominated space tend to be more idiosyncratic. We find more attractive valuations among the higher-yielding countries on a selective basis.
We are focused on issuers where we believe the risks may be overpriced or exposure could look to provide stability and resilience as part of a diversified fixed income portfolio.
Local currency bonds look particularly attractive, and we currently see the most value in Latin American countries, such as Mexico and Brazil, where interest rates have been raised early. This has helped keep inflation under control and has supported exchange rates. That said, select European sovereigns are starting to look attractive.
Investing broadly across the full opportunity set offers a compelling way to build a well-diversified portfolio to gain strategic exposure to this growing asset class.
*Edward Harrold is the fixed income investment director at Capital Group.