Even amid the lingering uncertainty, we believe emerging market (EM) debt must remain a core, strategic component of the portfolio for institutional investors. From higher yields to enhanced diversification, the asset class offers several benefits. Importantly, for EM hard currency sovereign bonds, the structural risk premium is approximately 370 basis points on average per year over the last two decades, with a realized default-related loss of approximately 50 bps per year.1 Investors in this subset of EM debt are therefore extremely well compensated for the risk they incur. The actual loss is significantly smaller than the risk perceived. As a result of this ongoing misperception, the structural premium can be harvested year-after-year for outsized cumulative returns.
It’s vital for institutions to understand the need to persist and reap the potential reward rather than jump in and out of the asset class because of potential left tail events (when the investment value moves beyond three standard deviations to the downside). Typically, a period of negative performance is followed by a sharp market rally, which was all too evident in the latter half of 2020. By staying the course, asset owners and managers should be able to capture the risk premium long term – instead of potentially ill-timing the market. In other words, time in the market is much more important than timing the market.
The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.
“By staying the course, asset owners and managers should be able to capture the risk premium long term – instead of potentially ill-timing the market. ”
A rich country-focus for strong return potential
Our country selection has delivered strong returns over multiple investment cycles.
Alpha from countries
Past performance should not be seen as an indication of future performance.
“Our research emphasis is on where we think the market has been wrongly focused, and on what is mispriced so we are able to explore the alpha potential of EM debt.”
The Emerging hot spots
In terms of where we see opportunities now, we continue to like the EM hard-currency high yield space, especially the BB-rated universe, as we believe there is value compression, lagging both EM investment grade, and U.S. high yield. Abundant liquidity from the U.S. Federal Reserve’s massive fiscal stimulus has led to greater inflows and higher prices for U.S. high yield, which has supported the relative attractive valuations for EM high yield, to where investors hesitate to flow because of the perceived higher level of risk.
Emerging market high yield spreads vs US high yield spreads
Another attractive area in the EM fixed income universe is EM currency. We expect economic growth in EM will surprise on the upside as a result of supportive liquidity measures, the increase in vaccine distributions, as well as the conclusion of the U.S. presidential election. In terms of valuation, the EM FX stands out as one of the cheapest asset classes versus its fundamentals. It is also less owned versus other EM asset classes. That is why we like emerging market currencies from the Brazilian Real and the South Africa Rand to the Russian Ruble and Indonesia Rupiah.
“We like the EM hard-currency high yield space as we believe there is value compression, lagging both EM investment grade, and U.S. high yield. “
EM to benefit from China-led recovery
On the whole, we believe both EM and DM growth are expected to pick up this year as a result of the COVID-19 vaccine. With EM in particular, the recovery could be faster than expected, based on China-led expansion – a country which has benefited from its own large fiscal stimulus. This has had positive implications for the rest of EM, especially for big commodity exporters like Latin America, and many of its trading partners in Asia.
Over the next few quarters, we anticipate EM debt will benefit from the structurally weakening U.S. dollar, increased economic growth, a gradual recovery in the tourism industry, and a supportive commodity outlook. We are cautious of the possibility for a sharp rise in core DM rates driven by inflation, but it is not our base case. Nevertheless, the virus has changed the macro fundamental matrix for EM, with the fiscal deficit now accounting for 10% of GDP overall, which is not sustainable and will need to be addressed by tightening fiscal and monetary policies at some point in the future, combined with structural reforms.
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J.P. Morgan EMBI Global Diversified Index – is an unmanaged, market capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
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