What you may not know about emerging market fixed income
Author: Sound Choices
April 16, 2019
Quantity, quality, maturity, opportunity
Previously, we covered the 5 reasons to reconsider emerging markets (EM). In this article, we focus in on the fixed income component.
What’s included in the EM universe?
Emerging markets are classified using a number of different metrics and slightly differ among organizations.
The S&P Dow Jones Indices, for example, classify countries by looking at a number of criteria, including the size of the country’s domestic market capitalization, how freely its currency is traded and the country’s economy, specifically its income per capita, also known as Gross Domestic Product (GDP) per person.1
Canada, with its average income of US$45,0322 is one of the “developed” countries. Countries with income per capita of lower than US$15,000 are labelled “developing” or “emerging“.1
This helps explain why Brazil, China and India are on the list of the 10 biggest economies, but are still considered “emerging” – the size of their populations translate into a relatively low per capita income.
Morgan Stanley, on the other hand, in compiling its Emerging Markets Index, looks at the country’s economic development, size, liquidity and market accessibility.
Frontier markets: the next “emerging” markets
“Frontier” markets – just like EM countries – can be classified using a variety of criteria, but are generally countries with even lower income levels than the emerging market counties and considered less developed based on their economic level and liquidity. In this frontier phase, globally recognized regulatory authorities and administrations are often still in early development, which potentially leads to lower levels of transparency, shareholder and corporate governance.
Interestingly, frontier fixed-income markets tend to be more advanced than their equity ones so you’re more likely to see securities from these countries in a fixed-income portfolio than an equity one.
Who issues EM bonds?
Sovereign bonds are issued by the government. With sovereign debt, the focus is on country risk, mostly driven by fiscal conditions.
EM companies also issue bonds. In fact, the EM corporate bond market is now bigger than the EM sovereign bond market (53% vs 47%, respectively).3 Corporate debt, not surprisingly, is assessed by looking at the company’s credit risk.
Supranational bonds provide alternative access to the emerging markets with a potential to migitate country-specific risks. These bonds are issued by international organizations, such as the European Union or World Bank. As they’re backed by multiple countries, they tend to have higher credit ratings and sometimes better liquidity. Borrowing nations belong to the organization and prioritize payments on these bonds.
How does currency factor in?
Bonds are issued in either external (hard) or local currency.
External currency bonds are issued in ‘hard’ currencies such as the U.S. dollar. Like all U.S. dollar-based bonds, they would be assessed by the spread over U.S. treasuries and therefore tied to U.S. monetary policy.
The first emerging market bonds were issued as external debt because the hard currencies are considered more stable. An EM country tends to offer a higher interest rate on a U.S.-dollar bond than those issued by the American government to take into account the risk associated with it being a developing nation.
Local currency bonds are exactly as they sound – debt issued in the currency of the EM country. Generally, local currency bonds pay a higher yield than external currency ones to compensate for the risk of investing in that particular currency. This type of bond would be assessed by considering quantitative measures such as the country’s monetary and fiscal policy, as well as qualitative issues like geopolitical concerns
Today almost 90% of EM bonds (approximately US$ 21.1 trillion) are denominated in local currency.3 Not surprisingly, an EM issuer would generally prefer to offer a bond in their own currency to avoid potential debt-servicing issues. (If the U.S. dollar appreciates after issuing an external bond, for example, the financial burden or repaying coupon payments and principle increases for that EM country.) A more robust domestic market enables the issuers to do just that. In fact, Asia is almost entirely self-sufficient – approximately 95% of Asian fixed income securities are domestic market bonds.3
Quality – EM bonds not necessarily junk bonds
Investors often compare EM bonds to junk bonds (also known as high-yield bonds, or those with a rating below BBB-), but the comparison can be misleading.
In fact, the chart below shows that, as of December 31, 2018, nearly 60% of EM bonds were rated investment-grade (BBB or higher).
Opportunity – An evolving, growing market.
EM fixed income has grown over the past two decades to a market valued at US$24 trillion4, including bonds issued in a variety of currencies.
That said, although the EM countries produce 50% of global GDP, they account for just 22% of global bond markets.3 The debt-to-GDP ratio is also much lower in EM countries than in developed ones; however, this has been growing as more EM debt gets issued.
This shows there’s room for the EM bond market to grow. Conservative estimates have it growing to US$40 trillion over the next five years.3
To learn more about income investing, visit AGF.com. To find out how emerging markets fixed income could help diversify your portfolio, talk to your financial advisor.
1Source: “S&P Dow Jones Indices’ 2018 Country Classification Consultation” released June 13, 2018.
2Source: https://data.worldbank.org/indicator/ny.gdp.pcap.cd, 2017 data, source April 4, 2018.
3Source: “The Emerging View, The EM fixed income universe version 7.0,” Ashmore, August 2018.
4Source: JP Morgan, as represented by JP Morgan GBI-EM Broad Index.
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