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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.
As we have discussed throughout this series, the health and stability of emerging markets has improved significantly in the new millennium. This historic progress has been well reflected in a steady improvement in the credit ratings of emerging markets bond markets as shown in the chart below. What has this meant for investors? An asset class that is less risky than it was two decades ago.
In the past three years, however, the asset class has encountered several headwinds, many of which are challenges that need be assessed country by country. From a credit perspective, these headwinds are reflected by the decline in the portion of the market rated investment grade.
In the 1990s, the large portion of emerging markets with high yield ratings reflected a much riskier asset class, as demonstrated by the structural imbalances and economic challenges found in many emerging markets at the time. Since then, credit ratings among emerging economies have exhibited long-term improvement. The primary contributors have been steady economic growth, favorable fundamentals, and structural reforms which have made economies more flexible and less vulnerable to external shocks.
In 1997, only 14% of the J.P. Morgan EMBI Global Diversified Index (which tracks the investable U.S. dollar-denominated emerging markets sovereign bond market), was rated investment grade. By 2013, nearly 66% (or two thirds) of the Index was investment grade.
Credit Quality of the J.P. Morgan EMBI Global Diversified Index1997 – November 2016
Source: J.P. Morgan as of 11/30/2016. Securities are categorized as Investment Grade if two out of three ratings from Moody's, S&P and Fitch are Baa3/BBB-/BBB- or higher. If a security has two ratings, both must be Baa3/BBB-/BBB- or higher. Otherwise, securities are categorized as High Yield. Past performance is no guarantee of future results.
Since 2013, the long-term improvement in credit ratings appears to have stalled. Several recent headwinds including the slowdown in China, a stronger U.S. dollar, and the collapse in commodity prices had a significant negative impact on several emerging economies. Brazil and Russia, which both lost their investment grade status in 2015, have accounted for a large portion of the downgrades experienced over this timeframe. Other countries remain on the cusp of falling into non-investment grade status and may be downgraded due to economic or political reasons, or both. Further, the dire fiscal and political situation in Venezuela has been a reminder of some of the inherent risks of investing in emerging markets.
With over half of the sovereign market rated investment grade, emerging markets bonds should not be viewed interchangeably with high yield corporate bonds or as inherently “risky.” Although there have been notable downgrades in the past few years, countries like Russia and Brazil appear to have stabilized and are showing signs of improvement. Further, there have been positive credit stories in countries such as Hungary, Indonesia, and the Philippines that should not be overlooked. Opportunities exist for quality focused investors to potentially achieve attractive yields versus developed market counterparts without having to go down the credit spectrum. More importantly, to the extent emerging markets continue to pursue structural reforms and enact policies that help foster economic growth, the asset class may benefit in the long term.
In my next post I will discuss current opportunities in emerging markets bonds. This series will continue in early January 2017. Happy Holidays.
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