• Emerging Markets Bonds

    How Fundamentals Boost the Case for Emerging Markets Bonds

    William Sokol, Senior ETF Product Manager

    The emerging markets debt market has evolved significantly over the past two decades, growing in both size and diversity. The market’s growth reflects the dynamic structural reforms that have transformed many emerging markets economies and helped boost economic growth. Also, investor understanding and appetite for emerging markets bonds has increased significantly as more investors recognize the asset class’s potential income and diversification benefits.  

    In this five part blog series, we advance the case for investing in emerging markets debt and identify some of the opportunities the asset class provides in today’s market environment.  

    Favorable Fundamentals

    Fundamentals of many emerging markets countries have stabilized and improved following the headwinds of the past few years. This post examines these favorable fundamentals.

    Although many emerging markets economies have been significantly impacted in the past few years by the collapse in commodity prices, the stronger U.S. dollar, and the slowdown in Chinese economic growth, fundamentals now appear to be stabilizing and, in some cases, showing signs of improvement. In addition, the longer-term fundamental rationale for investing in emerging markets remains intact. This is perhaps best characterized by the higher economic growth that emerging markets have enjoyed versus developed markets, over several decades.

    As a result, emerging markets today contribute approximately 39% of global gross domestic product (GDP) versus only 19% two decades ago (Source: IMF). Despite this growth, emerging markets have, on average, maintained steady and manageable debt levels through disciplined borrowing, in stark contrast to many developed countries which have seen their debt-to-GDP ratios balloon to more concerning levels.

    Emerging Markets Have Significantly Lower Debt-to-GDP Ratios versus Developed Markets  

    Emerging Markets Have Significantly Lower Debt-to-GDP Ratios versus Developed Markets

    Source: IMF.

    The economic growth advantage enjoyed by emerging economies stems from several factors, including favorable demographics, growing middle classes, increased urbanization, and improving infrastructure. From a policy perspective, much of the credit goes to reforms undertaken following several emerging markets debt crises in the 1980s and 1990s.

    Before the early 2000s, external debt denominated in U.S. dollars accounted for a much larger portion of emerging markets borrowing than it does today. A weaker local currency can significantly impact a country’s ability to repay its external debts, which may result in capital flight as investors pull out of vulnerable markets. In order to avoid the political, social, and economic disruptions of a large and rapid devaluation, countries may deplete foreign currency reserves to defend their currencies. In some cases, however, devaluations and even defaults can inevitably occur, which can shut off a country’s access to global capital markets for years and result in a lack of foreign investor confidence.

    Structural Reforms Have Strengthened Emerging Markets

    In response to the crises of the 1980s and 1990s, many countries adopted floating exchange rates, pursued structural reforms to enhance fiscal discipline, and increased local currency debt issuance to help reduce the vulnerability of their economies to external shocks. For many emerging markets countries, taken together, these reforms have increased foreign currency reserves and also resulted in secular reductions in borrowing costs.

    Emerging Markets Reserves and Spread vs. U.S. Treasuries
    As of October 2016

    Emerging Markets Reserves and Spread vs. U.S. Treasuries

    Source: Bloomberg.

    Since the greater adoption of flexible exchange rates, the ability and willingness of emerging markets central banks to use them as shock absorbers has been tested several times. The financial crisis of 2008 and European debt crisis thereafter provided significant tests for the new emerging markets model of lower external debt, higher reserves, and greater fiscal flexibility. In both cases, central banks took swift action to insulate their economies without depleting reserves to dangerous levels. The more recent “taper tantrum” of 2013 demonstrated that policymakers in many countries were willing to tolerate weaker currencies and higher interest rates in order to maintain stable reserves and control inflation.

    In summary, the fiscal stability of emerging markets has increased considerably in the past 20 years. Exchange rate flexibility along with higher reserves and healthier fiscal positions have allowed emerging markets economies to avoid a repeat of earlier crises, maintain market access, and help boost investor confidence.

    Next: A Look at Ratings Trends

    Next I will concentrate on how ratings trends reflect long-term progress while also touching on recent headwinds within the asset class.

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