Did you know that Emerging Markets Debt represents one-third of global debt?
Yet it is vastly underrepresented in most global investors’ portfolios.
By Michael Megarit.
Yesterday’s emerging economies are today’s economic powerhouses.
In 2020, Asia’s GDP overtook the GDP of the rest of the world combined. Further, the IMF believes that the difference in growth rates between emerging economies and developed markets will double over the next five years to more than 3%.
In fact, the World Economic Forum claims that by 2030, emerging economies will contribute more than 60% of global GDP. As these countries rise up the global GDP rankings, their underlying fundamentals also improve, sometimes surpassing their Western counterparts.
For example, the International Institute of Finance reports that total debt in emerging markets equals 214% of GDP, compared to 380% in developed markets. This means that emerging markets still have untapped debt potential that may help them spur economic growth even more.
This explains why US investors are starting to get very interested in Emerging Markets Debt.
What is Emerging Markets Debt?
Emerging Markets Debt refers to the fixed income securities issued by governments of emerging economies. Such securities include their equivalent of Treasury Bills, bonds, debentures, and any other interest-generating financial product backed by the taxation authority of those governments.
Like its Western counterpart, Emerging Markets Debt is appropriate for investors seeking relatively safe and reliable returns on investment. Often, fixed-income securities are integrated into portfolios as hedges against stock market volatility.
For many decades, United States government bonds were deemed by far the most attractive fixed-income investment in the world. In fact, Japan and China each hold more than $1 trillion worth of US Treasury Bonds.
However, data suggests this dominance may be coming to an end.
Developed Market Debt is Increasingly Unprofitable
Investors are waking up to the stark realization that most developed market debt is no longer attractive:
- The US 10-Year Treasury Yield is a paltry 1.61% and the 30-year is a modest 2.16%. Incredibly, this is as good as it gets in the Western bond market.
- Australia’s bond yields are comparable to the US’, with the 10-Year yielding 1.63% and the 15-Year yielding 2.02%.
- The UK Gilt 10 Year only offers a 1.16% yield, and the 30 Year a 1.50% yield.
- All German Bonds have negative yields, except for the 30 Year, which proposes a depressing 0.33%.
- Japan’s 2-Year and 5-Year yields are both negative, its 10-Year a meager 0.08%, its 20-Year a slightly better 0.46% and the 30-Year a weak 0.69%.
- Finally, French government bonds are among the worst of the developed world, with the 10-Year yielding 0.18%, the 20-Year yielding 0.61% and the 30-Year yielding 0.99%.
Once you factor inflation, which averages roughly 2% per year in the USA, real returns on all of these bonds are overwhelmingly negative.
Very few investors will accept real negative returns over a prolonged period of time.
With near-zero interest rates appearing to be the “new monetary normal”, they are now actively seeking fixed-income products with greater yields.
Emerging markets offer just that.
Emerging Markets Debt is Increasingly Profitable
For years, investors steered clear of Emerging Markets Debt because of economic instability and rampant inflation.
For example, the trauma of the 1997 Asian financial crisis left wounds that took more than 10 years to heal. Until recently, these countries had to offer higher yields to compensate for the great risks of inflation. Even then, inflation often eroded the value of the bonds, leaving investors with very modest – not to say underwhelming and even negative – returns.
However, over the past decade, Asia has grown at a phenomenal pace, while developed markets have struggled to post 1-2% annual growth rates.
Today, many emerging economies offer better inflation-adjusted yields than their Western counterparts. In fact, since 2011, the average real yield of Emerging Markets Debt is 2.5%.
In comparison, since 2011, developed markets’ ex-ante real yields are a dismal -0.65%!
China’s Bond Market is of Particular Interest
With a market value of more than $14 trillion and an annualized growth rate of 18%, China’s bond market is the second largest in the world. While it is still driven mainly by local investors (foreign ownership is less than 3%), it is poised for its next growth stage: international investments. Indeed, prominent analysts believe this will be driven by the increased importance of the Chinese economy on the world stage and the progressive regulatory alignment with international standards.
To give an idea of historical performance, BlackRock’s BGF China Bond Fund has generated an average annual return of 5.29% since its inception in 2011. In comparison, BlackRock’s BGF US Dollar Bond Fund generated an average annual return of 3.13% over the same period.
While a 2 point percentage doesn’t appear significant, this compounds to an enormous gain differential if you adopt a 10-20 year outlook.
Similarly, BlackRock’s Emerging Markets Bond Fund, which invests in the fixed income securities of countries such as Egypt, Ukraine, Mexico, Ghana, Indonesia and Chile, generated an average annual return of 4.65% since 2011. As you can see, this return is also far superior to US bonds.
It’s now clear as day why fixed-income investors are injecting their capital into Emerging Markets Debt.
Emerging Markets Debt is Underrepresented in Global Portfolios
Financial data is clear: Emerging Market Debt is underrepresented in global portfolios by a factor of almost 5.
The Bloomberg Global Aggregate Index shows that the weighting for Emerging Market Debt is only 6%, while China and India alone account for 27% of global GDP!
Clearly, investors will rebalance their portfolios to incorporate more emerging markets debt. As the balance of economic power shifts from West to East, so will investment capital.
By 2030, Asian bonds will represent a significant share of the Bloomberg index.
Emerging Markets Debt is gaining in popularity, but some investors still fear these countries’ instability. Is this a valid concern?
In part, yes.
However, “emerging markets” is an all-encompassing term that often obfuscates different case-by-case realities. Once you look underneath the surface, you will find that many emerging markets present solid fundamentals.
Most Emerging Markets Debt is Safer than You Think
Emerging Market Debt is not as risky as it’s usually portrayed.
Investors know this and are adopting a flexible, unconstrained approach focusing on specific high-growth countries with solid fundamentals.
The data proves this.
While the local currency debt market is worth $24.8 trillion, Asia represents 78% of that total amount, and China 57%. In addition, Brazil, South Korea and India each have sizeable local bond market worth well over $1 trillion in size. Hong Kong, Mexico, Singapore, the United Arab Emirates, Turkey, Russia and Indonesia are the other countries attracting the most investor interest. As you may know, all of these countries are growing and developing rapidly.
Investors are identifying the “best-of-breed” emerging markets and investing their capital into their fixed-income securities. Countries that don’t pass the stability screen test are simply ignored for now. That may change as economic conditions evolve and improve.
For now, there is plenty of untapped potential in markets such as China, India, Indonesia, Brazil, Mexico, and Ukraine, to name just those.
One thing is clear: you will hear more about Emerging Markets Debt in the coming years.
What This Means for Investors
As emerging economies pursue their grow trajectory, they will continue attracting investor interest. If Western nations persist with near-zero interest rates, low and negative government bond yields will push investors towards higher-yield, middle-grade (and theoretically riskier) fixed income products.
Since many emerging economies are in full bloom, their governments are solvent and fully able to honor their debt obligations. Further, they understand the structural shift in power that is occurring and they are more than happy to welcome and encourage international investment.
Why wouldn’t they? This influx of capital contributes to the virtuous cycle of growth that is elevating their economies towards developed status.
Finally, Emerging Market Debt will inevitably grow because of its underrepresentation in global benchmarks. There is no rational reason why 30% of the world’s debt makes up only 7% of portfolios.
Investors understand this and are taking action.
About the Author
Michael Megarit is a partner with Cebron Group.
With over 25 years of domestic and international corporate finance experience,
he provides M&A and capital advisory to high-growth technology companies.