Beyond Bulls & Bears

The Case for Emerging Market Debt

Many investors have an innate “home country” bias, giving them blinders when it comes to opportunities beyond their own nation’s borders. But the economic outlook for your home country might be quite different from one halfway across the globe—or even right next door. Emerging markets may be viewed as a world away to investors in developed markets, but they can make a potentially compelling investment story for those seeking diversification. William Ledward, Senior Vice President and Portfolio Manager for Franklin Templeton Fixed Income Group based in London, makes the case as he sees it for emerging market debt.

Ledward’s key points:

William Ledward

• Emerging markets have become a greater part of both the global economy and capital markets in the last decade, a trend that he believes is likely to continue.

• Economic fundamentals in many emerging markets appear healthier in his view today than in many developed countries, even though yields on many emerging market debt issues are generally higher.

• Credit quality, liquidity and governance in emerging market debt have generally improved over the last 10 years.

Leading benchmarks of emerging market (EM) debt have held up reasonably well despite a rise in risk aversion among investors.1 This is not surprising to Ledward, when considering the relatively strong economic position of many EM countries and the significant yield premium that many EM bonds currently offer over their developed-country counterparts. In terms of economic growth, emerging markets in general have outpaced developed markets since 2000. (For example, in 2011 U.S. GDP was below 2%, vs. 13.5% in Ghana and 9.2% in China.2) Emerging markets have a relatively healthy fiscal position too, with generally lower debt-to-GDP ratios than most developed economies. Here’s why Ledward thinks EM debt is likely to score more attention from investors.

[php function=1]“The 2008–2009 global financial crisis brought into sharp focus the relative strengths of emerging market economies, and we believe their share of global GDP is likely to continue to increase at the expense of developed countries. An expanding middle class with rising disposable incomes in many emerging markets has fuelled the rapid growth of domestic demand and intraregional trade. Over the past decade, liquidity in emerging markets has substantially improved as both the variety of investment opportunities and the investor base has broadened. Furthermore, the sizable foreign currency reserves built up by many emerging markets have helped their currencies to appreciate, boosting returns for investors in developed markets, with potential for further gains if this were to continue.“

It has taken time for EM debt to move into the mainstream investment universe, primarily because major ratings agencies put EM sovereign issuers predominantly below investment grade, based on weak government finances and poor institutional governance. But things are starting to change.

“Successive crises—most significantly, the 1998 Asian crisis—prompted many developing countries to favor export-led growth and switch from fixed to floating exchange rates, allowing them to amass foreign exchange reserves and reduce their vulnerability to short-term market fluctuations. According to our research, the average credit quality of EM sovereign bonds has been increasing.”

Increased Liquidity Across Sovereign and Corporate EM Debt

Investor sentiment or perception is extremely important to a market’s fate, and Ledward notes that one of the key turning points in building confidence in EM debt occurred in 2003. Through fiscal tightening, Brazil managed to avert a potential default, and Investors’ appetite for the asset class has continued to build since then. While Brazil and other emerging economies are facing some fallout from the eurozone crisis and coping with slower growth this year, past fiscal prudence should work in the favor of many emerging markets, says Ledward.

“In aggregate, emerging markets now only have around a third of the debt of their developed peers. A significant number of EM countries and companies hold investment-grade credit ratings. The stability and improved fundamentals of many EM sovereigns have opened up capital markets for the EM quasi-government and nongovernment corporate sectors, resulting in a steady increase in both hard-currency (US dollar, euro and Japanese yen) and local-currency denominated issuance. This has helped enhance the liquidity and depth of the asset class. EM corporate issuance has significantly expanded in recent years, both in absolute terms and relative to levels of EM sovereign issuance. With growth in EM economies consistently outpacing that of developed countries since 2000 and underpinned by substantial flows of foreign direct investment, EM companies have sought access to long-term financing outside of their local markets to allow them to take advantage of potential opportunities offered by globalization and M&A.”

Decreased Dependence on Developed Economies

There has been much discussion about the extent to which emerging markets have “decoupled” from advanced economies. Within an increasingly globalized world, in Ledward’s view, it appears unlikely that emerging markets could ever be completely insulated from the economic fortunes of developed countries. This was certainly the case during the 2008-2009 financial market crisis, which began in the U.S. and Europe. However, EM economies generally suffered less than developed markets during that time, and some managed to maintain attractive growth rates.

“This would suggest there are secular drivers of economic growth at work in emerging markets. One of the most important drivers is intra-EM trade, which rose from only 6% of world trade in 2000 to 13% in 2010.3  According to Citigroup estimates, intra-EM trade is forecast to account for 27% of world trade in 2030, overtaking the value of trade between advanced economies, and for 38% in 2050.2 Should the eurozone crisis deteriorate and deliver a Lehman-type shock to the global economy, it would certainly impact emerging markets, but whether this multiyear trend—whereby emerging markets have been taking an ever-larger slice of world trade—would be affected, is questionable in our view. So, while some of these countries may continue to have greater exposure than others to, for example, commodity prices or capital flows, the case for a decreasing overall EM dependence on the G3 economies seems persuasive to us.”

Ledward has also seen evidence that corporate governance seems to be improving and that wider adoption of international accounting standards by these countries over the last 10 years has increased transparency and improved the backdrop for prospective investors. Better bankruptcy procedures have enhanced the recovery rates possible on defaulted bonds, too.

“In our view, EM debt represents a potentially interesting segment of the market for investors seeking to increase diversification away from more established markets. In parallel with the expansion of the opportunity set, the quality of the investment universe appears to have risen as well. Therefore, we believe that the outlook for returns from the asset class, when compared with yields from some of the largest developed sovereign and investment-grade bond markets, could remain attractive.”

Want to learn more about emerging markets from an equity investment standpoint? Read Mark Mobius’ blog, “Investment Adventures in Emerging Markets

Get more insights from Franklin Templeton delivered to your inbox. Subscribe to our Beyond Bulls & Bears blog.

What are the Risks?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year.

 


1. Source: J.P. Morgan Emerging Market Bond Index Global, J.P. Morgan Emerging Market Bond Index Global Diversified and J.P. Morgan Emerging Market Bond Index Plus.

2. Source: Central Intelligence Agency CIA World FactBook.

3. Source: Source: Citi Research, “Trade Transformed, The Emerging New Corridors of Trade Power,” October 2011.