On average, European investors allocate 6% of their portfolios to emerging markets debt (EMD), even though EM accounts for more than 60% of global GDP and is home to roughly 90% of the world’s population. Without increasing their exposure to EM, many people pass up an opportunity to diversify their portfolios.
Emerging market debt in hard currency (EMD HC) has several important qualities, including:
- Attractive rates: Compared to developed market debt, EMD HC yields are substantially higher, and a large percentage of the universe is rated investment grade, so there’s excellent long-term return potential.
- Stability and resilience: Contrary to expectations, emerging markets (EMs) have strengthened their economic foundations, making them less susceptible to fluctuations in economic conditions around the world.
- Diversification: EMD HC offers exposure to a diverse range of nations, which fundamentally diversifies risk. By combining the risk premium of emerging markets with the safety features of firm currency bonds, it offers a way to diversify one’s portfolio.
We believe that indexes and passive exchange-traded funds (ETFs) fail to take advantage of opportunities presented by active management strategies due to the asset class’s inherent complexity and inefficiencies.
Investors may be missing out on this developing asset class’s potential because of these 10 prevalent misconceptions:
1. Uncertainty in the value of currencies and interest rates saps gains from emerging markets.
EM debt denominated in hard currency is significantly less vulnerable to fluctuations in local currency. To rephrase, “hard currency” actually refers to less local currency risk, as returns are mostly influenced by US Treasury rates and credit spreads rather than fluctuations in local currencies.
2. EM is an unrated junk debt.
Currently, investment-grade ratings apply to more than half of the world’s emerging market (EM) unsecured currency debt. Yields comparable to US high-yield bonds, but with better fundamentals and average credit quality, have been offered by an asset class whose average credit rating has increased dramatically over the previous 20 years.
3. Investing in EM debt is consistently unwise.
Emerging market sovereign debt markets have become increasingly complex and extensive. Several nations have shown they can withstand external shocks better than their industrialized counterparts, have increased fiscal discipline, and have accepted structural changes.
4. Emerging Market Debt Is Spellbound And Lacking in Diversity
Hard currency bonds issued by emerging market countries offer substantial diversification, with more than 70 countries offering debt across a range of credit ratings. From Southeast Asia to Latin America, the market includes energy exporters, service economies, and manufacturing hubs, offering a diverse range of exposure.
5. Emerging Market Debt Is Very Vulnerable
The volatility is greater in US high-yield credit than in stocks or emerging market equities, but it is still noticeable. Foreign currency debt from emerging markets has become more resilient, especially in times of global market stress, as a result of improving credit quality and more investor participation.
6. Passive ETFs Can Beat Active Managers
Due to idiosyncratic risk or geopolitical noise, the EM sovereign debt market is inefficient, and mispricings occur frequently. Active managers have a track record of success because they capture value through activities such as yield curve positioning, selective risk-taking, and thorough nation research.
7. EM defaults are common and disastrous.
Rare are sovereign defaults in EM, and recovery rates are frequently better than people think. Many nations now actively manage their debt loads and engage constructively with creditors, and the asset class has developed thanks to access to multilateral support (e.g., the International Monetary Fund).
8. Hard-currency EM debt is not well-diversified across regions and sectors.
An important strength is the variety of the market. The hard-currency universe of emerging markets is significantly more diverse than common perceptions would have you believe, including commodity-rich African states, technology exporters from Asia, and border economies in Europe.
9. Emerging Market Debt Is Trapped by Rising US Rates
Rate hikes may cause a temporary reaction in EM spreads, but solid fundamentals usually end up winning out in the end. Emerging markets (EMs) that have strong fiscal buffers, reform momentum, and external balances are more likely to do well, even when times are hard.
10. A high dollar negatively impacts the returns on hard currency in emerging markets.
A high dollar has less of an impact on hard currency than it does on local currency EM debt. Credit spreads and US Treasury movements continue to be the critical variables for hard currency sovereigns. Another way that many EM issuers mitigate dollar-related pain is by keeping reserves in USD.
Contrary to popular belief, the EMD HC asset class offers a fascinating chance for long-term investment. Many people mistakenly believe that emerging market hard currency debt is an extremely dangerous phenomenon. A modern fixed income portfolio would be remiss without it, thanks to its attractive yields, improved fundamentals, and robust diversification benefits.
