Why emerging market debt needs both a passive and active approach
Most investors already allocate to emerging market debt (EMD). It is an area of investment that has become an established part of many fixed-income portfolios. EMD now represents 18.0% of global bond issuance, which is significant.¹
However, most investors also still hold far less than this amount as a fixed income allocation. In the past, smaller allocations may have been warranted. Back then there was less liquidity, greater default risk and less diversity to be found in EMD.
This picture has now changed. EMD as a market has matured. For instance, many sovereign bonds issued in emerging markets have gradually been rated upwards, moving from high yield to investment-grade status. By contrast, many developed market issuers have experienced moderate downgrades since the financial crisis 13 years ago. Subsequently, there has been a convergence in credit quality between the two.
Emerging market bonds have become an established group of asset classes
EMD is no longer a niche allocation. It has swelled to over USD 4.6 tn in assets in just two decades (see Chart 1). It should also not be defined as a single asset class, but rather as a series of different asset classes that offer unique sources of risk premia (see Chart 2).
There’s a huge variety of emerging market bonds available
There are hard-currency emerging market bonds. These include sovereign bonds (issued by governments) and corporate bonds (issued by companies). Both are asset classes in their own right.
These hard-currency bonds are typically denominated either in US dollars or other major currencies, such as euros, pound sterling or Japanese yen. The hard-currency market alone accounts for USD 3 tn in assets. To put this into context, this is half the size of the US investment-grade corporate bond market, and more than twice the size of the US high-yield market.2
Added to hard-currency bonds, there are also local-currency emerging market bonds. This market has grown rapidly over the past decade. Burgeoning US government deficits and the potential for a future weakening of the US dollar has encouraged greater levels of local currency bond issuance from emerging markets. From an investor’s perspective this offers even more ways to diversify a fixed income portfolio and provide additional sources of risk premium.
Overall, this has become a huge and diverse market that is difficult to ignore.
Investors should combine both a passive and active approach with EMD
There are benefits from combining both a passive and active approach to emerging market debt. In combination, both can offer a very effective way to manage an emerging market debt portfolio.