Why Emerging Market Debt Needs Both a Passive and Active Approach

Emerging Market Debt

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).

Chart 1
The emerging market debt universe has swelled to USD 4.6 trillion
Source J.P. Morgan indices, as of May 31, 2021

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

The emerging market debt universe is vast and complex
Source J.P. Morgan indices, Credit Suisse (May 2021)
*CEMBI – Corporate Emerging Markets Bond Index, EMBIG – Emerging Market Bond Index Global

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.

Pas­sive in­vest­ing

There are now sig­nif­i­cant amounts of liq­uid­i­ty of­fered across the emerg­ing mar­ket bond uni­verse as the mar­ket has ma­tured. There have also been sig­nif­i­cant tech­no­log­i­cal de­vel­op­ments in bond in­dex­a­tion, which have helped in­vestors gain quick ac­cess to this mar­ket while min­i­miz­ing track­ing er­ror risk.

 

This gives in­vestors an enor­mous amount of flex­i­bil­i­ty in man­ag­ing their over­all ex­po­sure to emerg­ing mar­ket bonds, re­gard­less of which as­set class they fo­cus on. It is rel­a­tive­ly easy to quick­ly add or re­move ex­po­sure to an in­dex and there are a wide va­ri­ety of in­dices on of­fer. Two of the most pop­u­lar are the JPM EMBI Glob­al Di­ver­si­fied in­dex, which com­pris­es USD-de­nom­i­nat­ed debt, and the JPM GBI-EM Glob­al Di­ver­si­fied in­dex, which con­tains lo­cal cur­ren­cy debt.

Ac­tive in­vest­ing

Be­yond pas­sive in­vest­ing, there are also a va­ri­ety of risk pre­mia on of­fer if you take an ac­tive ap­proach. For in­stance, there are in­ef­fi­cien­cies found across EMD due to the size and com­plex­i­ty of this mar­ket. This is an area where ac­tive port­fo­lio man­age­ment can add val­ue.

 

Emerg­ing mar­kets dif­fer in how they is­sue and struc­ture debt. An ex­pe­ri­enced ac­tive in­vestor un­der­stands these dif­fer­ent mi­cro-struc­tures with­in each mar­ket and can take ad­van­tage of these dif­fer­ences.

 

They can also gain ex­po­sure to bonds that lie out­side the in­dex and ac­tive­ly po­si­tion them­selves rel­a­tive to an in­dex to man­age ex­po­sure to in­ter­est rate risk or cred­it risk. Over­all, the broad­er uni­verse that an ac­tive man­ag­er has ac­cess to can help them im­prove liq­uid­i­ty, the lev­el of yield and ex­po­sure to du­ra­tion risk.

 

They can also take ad­van­tage of spe­cial sit­u­a­tions. For in­stance, they could tac­ti­cal­ly tilt into dis­tressed bonds that are shunned by risk-averse in­vestors. They can also cap­i­tal­ize on in­ef­fi­cien­cies with­in the mar­ket by ei­ther sell­ing emerg­ing mar­ket bonds in an­tic­i­pa­tion of a down­grade or buy­ing at low­er prices fol­low­ing a down­grade.

 

An­oth­er in­ter­est­ing source of re­turn is through the pri­ma­ry is­suance mar­ket. Un­like an in­dex, ac­tive man­agers can ac­tive­ly par­tic­i­pate dur­ing is­suance sea­son. They can also take ad­van­tage of small­er is­suers that an in­dex might not cap­ture due to liq­uid­i­ty con­straints with­in the in­dex.

 

There are ben­e­fits from tak­ing both a pas­sive and ac­tive ap­proach to emerg­ing mar­ket bonds. By com­bin­ing the two, an in­vestor can build a dy­nam­ic and well di­ver­si­fied emerg­ing mar­ket debt port­fo­lio.

1 J.P. Morgan
2 J.P. Morgan

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