The under-the-radar asset class you should be paying attention to

If Livewire were ever to run a poll for the “least sexy asset class”, I humbly submit that emerging market debt would be close to the top of that list.

It’s a tough sell as it’s not particularly well known, and there aren’t a lot of fund managers who provide access to the opportunity in Australia.

But just because it isn’t sexy, or dominating the headlines, it doesn’t mean you should ignore it. In fact, it might be one of the few remaining under-the-radar investment opportunities going around.

Of course, all of that would mean nothing if the returns weren’t any good, but emerging market debt provides some of the highest yields in the fixed income universe right now, and with less risk than you might expect.

How is that the case?

A retelling of the tale of the two squirrels may help. One squirrel prepared for winter by working hard and storing food. The other was too busy playing and found itself in significant trouble come winter.

Well, in the financial world, the winter was the economic winter that befell the world during and after COVID. The playful squirrels were the developed markets (think the US, UK and Australia), running up deficits and making sure our standard of living didn’t drop. Meanwhile, emerging markets were the squirrels that saved and prepared.

As such, emerging market fundamentals are much stronger than they used to be. They’ve already taken their medicine, whilst developed nations are still out partying like it's 1999.

According to BlackRock, credit quality in emerging market debt has improved significantly and is converging with that in developed economies. In June 2005, 40% of EMD was rated investment grade, whereas 60% was rated high yield. A decade on in June 2015, nearly two-thirds of EMD is now classified as investment grade, with only one-third rated as high yield – and that trend continues today.

So, theoretically, you can get an excellent return on EM debt for much less risk than used to be the case.

But as always, you need to know what you’re doing. There are still significant risks if you don’t know where to play - just as there is with any asset class.

With all this in mind, I recently sat down with Grant Webster, Co-Head of Emerging Market Sovereign & FX at Ninety One, to talk all things EM debt.

LW: What is the size of the opportunity in emerging market debt?

Webster: The asset class is much bigger than people understand it or expect it to be.

Emerging market debt is now more than $20 trillion in total, and sovereign emerging market debt is now well over $10 trillion. It's a very significant asset class - much bigger, deeper and more liquid than most people are led to believe.

How is emerging market debt characterised?

The biggest distinguishing factor in emerging market debt is the currency that it's issued. Debt that's issued by emerging markets in their own currency, we call that local currency debt.

Whereas if a country issues in [US] dollars or euros or yen or sterling, it's what we call hard currency debt. 

That's a key distinguishing factor, and those two distinct asset classes perform quite differently and they look very different to each other in many different ways.

The local currency market is the bigger of the two, by far. The hard currency market is about $1.5 trillion, so it's big, but it's not enormous. The rest, $10 trillion or more, is going to be local currency debt.

The countries that are issuing the different types of debt also differ quite a bit. Your bigger, more well-established, higher credit quality countries, typically issue more local currency debt, because they've got bigger domestic markets. They've got big banking sectors, pension funds, and savings industries, and those industries can absorb that paper.

Although you still get the large, liquid, highly credible EMs issuing dollar debts, there's a long tail of countries that are smaller and they also issue dollar-denominated debts. They might not have as much local, so they're still developing. They don't have big local pension funds or savings industries. They're trying to track capital, they're trying to grow, and so the best way for them to do that is by issuing hard currency dollar debt. Those are big distinguishing factors.

What risks do investors need to be aware of?

Let's elaborate a little bit more on this dollar debt versus local debt, and that'll help us understand the risks.

If you consider local currency emerging market debt like you would Australian debt, issued by the Australian government in Australian dollars, the key risk there really is local interest rates - what the central bank is doing and also how much the government is borrowing, so your demand and supply for bonds.

The driving factors behind that are growth and inflation. Those are big things, so the central banks have been raising rates because inflation is high, and so those are key risks for local currency debt.

As foreigners, or international investors investing in local currency debt, the currency is a risk as well because you're taking on currency risk. You're taking on the volatility. Whereas on the dollar debt side, it's already in dollars, so if you're a dollar-based investor, there's no risk there.

It's a bit different in dollar debt because, unlike local debt, when a country issues or borrows in dollars, they have to generate dollars to pay you back. They can't print the dollars, they have to generate them through exports and the like.

It's much more of a credit asset - hard currency debt - and it trades like corporate debt almost, or credit. It has a spread over Treasuries, and that's how it gets valued. 

Your risk in hard currency debt is much more around credit quality and the ability of these countries to repay you in dollars, whereas the risk on the local side is inflation, monetary policy, and money supply. 

Those are very distinguishing factors, and you've got the currency exposure as well. Those are all risks that we consider.

What is the outlook for emerging market debt and what have you been adding to the portfolio?

We're quite encouraged by the outlook.

Over the last 18 months or so, we've been through an environment of very high inflation, as everyone knows, rising interest rates. The dollar has been very strong over this period, so it's been a challenging environment for all asset classes.

Having said that, when you look at the performance of emerging market debt, it's been doing very well. 

It has been outperforming developed market debt, which is astounding. In the past, that would never happen.

The reasons behind that are that the fundamentals are a lot better. The economic fundamentals have improved because of the period after 2013 when they [emerging markets] had to improve. They were running big deficits in 2013 and those have contracted, so the fundamentals on the whole are better.

In emerging markets, the central banks hiked rates very early on. They tackled inflation very credibly, in a very orthodox fashion. 

For them, it wasn't unusual to see these high levels of inflation. 

Emerging markets go through these cyclical moves. For developed markets, it was like a 40-year event, but for EM it wasn't unusual. They saw it coming. They hiked interest rates, they took the medicine, and now they're reaping the reward.

The flows into emerging market debt have been a lot slower over the last few years. You don't have a lot of investors in the asset class, and that's a good thing when dollar liquidity is tightening because it means there's no money to leave. They've performed well and they've outperformed developed markets, and we think that's going to continue.

How are you positioning your portfolio?

We are overweight both the local currency debt and the hard currency debt components, which we can do by investing in longer-duration bonds and slightly more risky countries, because we anticipate rates to be coming down more next year.

We think that the valuations in hard currency debt remain very attractive. You've got very high credit spreads in those markets, particularly in high-yield debt, and especially relative to, for instance, developed markets' high-yield corporate debt. We think those can do well.

The one area we remain a little bit more cautious is EM currencies. They're doing well now, but if you think of the global dynamic where the US is still performing quite well relative to Europe in particular, the Fed is going to keep policy tight relative again to Europe and the rest of the world. That's an environment where the dollar can probably still perform quite well. 

In terms of preferences, we prefer the bond asset classes, and we hedge that a bit with the EM currency exposure.

What is your big, hairy prediction for markets?

I think that contrary to a lot of expectations, the US won't head into recession next year.

Many people expect a soft, mild recession. I think the US can avoid it. 

Fiscal policy is extremely loose. The job market is hanging in there very well. It's a very dynamic economy, and because inflation's coming down faster than expected, the Fed is just going to bring forward their interest rate cuts. That will ease financial conditions very quickly.