Emerging market debt presents opportunities for high returns but is also associated with specific risks.
As part of the management of a diversified bond portfolio, the investment can generate performance on at least two levels: the first via the periodic interest rate and the second via an appreciation of the price of the issue ( before its reimbursement or resale on the market). However, with regard to a bond instrument, price appreciation occurs when rates fall or when the bond approaches maturity if the purchase price is below par. Note that a third variable can contribute to the total return of a bond investment over time. This is the change in the currency of the bond instrument when it is issued in a currency other than the investor’s reference currency. A favorable or unfavorable change in the exchange rate in relation to the reference currency of the portfolio (or the investor) therefore also influences the performance of the bond investment.
In our previous writings, we have regularly returned to the principle of decorrelation in the process of constructing a bond portfolio. In this process, when the manager aims for optimal diversification, the challenge is to achieve an allocation allowing the full potential of issuers and categories of issuers displaying positive performance with a view, in particular, to making up for poor performances displayed elsewhere. . When we take these different aspects into account, we understand that investing in the bonds of emerging countries allows us to achieve such an objective.
For the reasons that we will recall below and which relate to both technical and fundamental elements, investors cannot ignore the debt of emerging countries as a truly optimizing element in their portfolio construction.
1981 vs. 2024: inflation, the surprise guest
Until recently, we had to deal with extremely low or even zero interest rates for the sovereign debt of developed countries and even certain private issuers. Under such conditions, a bond portfolio owed its good performance only to the receipt of interest (however low) coupled with a continuous fall in yields in a disinflationary context. In 2021, inflation returned, particularly in the euro zone and the United States. Indeed, while the American consumer price index fluctuated around 2% or even 1% over the previous decade, it recorded a strong rise with a peak reached at 9.1% in June 2022 (see article “Management bond and rise in rates” on this subject). The last time these levels were observed was in 1981. This return of post-Covid inflation therefore led to a clear halt to the downward trend in bond rates that began in 1981 (when the US 10-year rate was around 16%). . This rise could have given hope for a new context conducive to bond management benefiting from issues offering high coupons. However, as supply chains re-established and central banks raised interest rates, inflation eventually fell again. This made it possible to interrupt the rise in rates, for the time being. Indeed, in the euro zone, the ECB has started a new cycle of rate cuts while Germany announces its entry into recession.
Fundamentals and Markets
With regard to these market considerations, it is important to take into account the evolution of fundamentals (governance and solvency criteria, in particular). At this level, let us understand that formerly industrialized countries (or Western countries) have recently seen their debt level deteriorate due to massive budgetary spending and “exceptionally accommodating” monetary policies. This ended up weighing on the attractiveness and credibility of their currency and more generally on the quality of their signature as borrowers. In this regard, the case of France’s budgetary slippage is particularly eloquent. In the meantime, within a good number of emerging countries, we have witnessed more budgetary rigor and monetary orthodoxy in several cases, against a backdrop of the emergence of a middle class, growing industrialization and increased regional integration.
Illustration: the private sector as an embodiment of the emergence of the “Southern countries”.
The private sector is a crucial lever for development in emerging countries, contributing to job creation, economic diversification and innovation. Companies like FEMSA (Mexico), Tencent (China), Embraer (Brazil) and SABIC (Saudi Arabia) illustrate this dynamic well.
FEMSA, with a turnover of $27 billion and more than 300,000 employees, demonstrates how a favorable business environment can encourage growth. In Brazil, Embraer generates more than $5 billion in annual revenue and employs more than 18,000 people, benefiting from regulatory reforms that facilitate technological innovation.
In its Business Ready 2024 report, the World Bank highlights improving business conditions in countries like Mexico, Vietnam and Indonesia, with reforms that simplify access to financial services and improve public infrastructure. These advancements enable local businesses to compete internationally while supporting national economic growth.
This state of affairs is reflected in the financial markets. Over the years, emerging market debt has established itself as an asset class in its own right, attracting investors seeking healthy portfolio diversification while benefiting from higher returns. Over time, for lower volatility, the asset class displays superior historical performance and a performance potential that nonetheless remains intact.
Recent developments
The performance of emerging markets has been both dynamic and transformative over the past decades. As developing countries continue to represent a growing share of the global economy, investing in their debt instruments has become a strategy to capture this growth. Emerging market debt encompasses bonds issued by governments and companies in these economies, offering higher yields than their developed market counterparts. In this case, the market for corporate debt from emerging countries and denominated in dollars has almost doubled in the space of a decade to stand at nearly 2,500 billion dollars in 2024. This growth is particularly driven by growing demand for high-yielding debt. Today, at the sovereign level alone, the average yield on emerging country bonds stands at around 7.7% in dollar terms, compared to only 4.2% for US Treasury bonds.
In conclusion: an asset class that is both risky and resilient, essential for a bond portfolio that wants to be diversified
Emerging market debt presents opportunities for high returns but is also associated with specific risks. These include political and economic instability, currency volatility and liquidity risks. Emerging markets are often more sensitive to political upheaval, as evidenced by the debt crises in Argentina and Sri Lanka. In addition, the fluctuations in exchange rates that we mentioned above can erode gains, particularly for bonds denominated in local currencies. Periods of depreciation, such as those observed between 2014 and 2016, have highlighted the challenges that these investments can pose. However, despite these challenges which can contribute to fueling some preconceptions, emerging markets have shown remarkable resilience in the face of recent economic shocks. In a report dating from last June, the Bank for International Settlements highlights the improvement in this resilience thanks to structural reforms and the increased credibility of central banks. Unlike previous cycles, emerging market central banks were able to anticipate the post-COVID surge in inflation, thereby strengthening economic stability in these regions. The introduction of inflation targeting policies and more flexible exchange rate regimes, prior to the pandemic, helped stabilize investor expectations and reduce volatility risks. Furthermore, emerging markets now represent more than 50% of global GDP, and by 2030, 60% of global middle class spending is expected to come from these regions. The expansion of this middle class, coupled with the advent of booming business sectors, is of certain interest to investors. Indeed, as part of a diversified bond portfolio strategy, taking into account emerging market debt makes it possible to capture higher performance potential while improving the resilience of the portfolio in the face of global macroeconomic fluctuations. Therefore, integrating these assets into a portfolio is no longer simply an option but a necessity for investors wishing to optimize their long-term performance.
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