Emerging market (EM) countries were once volatile and unstable, but today they benefit from strong macroeconomic fundamentals relative to their developed-market counterparts.
We have witnessed the increase in the breadth as well as the depth of emerging market debt (EMD) and believe it is worthy of consideration in its own right for many investors’ portfolios.
Historically, local debt markets were under-developed, and as a result, emerging countries primarily issued hard-currency debt, mostly in US dollars.
In some cases, this practice contributed to foreign exchange and debt crises as exchange rate fluctuations caused liabilities in hard currencies to balloon (for example, Argentina in the early 2000s).
However, as macroeconomic fundamentals have improved in EM countries, local currency markets have also deepened, reducing dependence on external debt and avoiding the associated risks.
Recent data has shown that government issuances of hard-currency debt has significantly declined, which suggests that sovereigns are shifting away from issuing hard-currency debt thereby reducing future foreign exchange risks.
When combining the local- and hard-currency debt universes, the non-governmental sector (ie, financial institutions and corporates) accounts for roughly 52 per cent of the total debt outstanding, signaling growing issuance and a deep opportunity set beyond sovereign debt.
Deepening of capital markets as well as a higher degree of economic development in emerging nations is evidenced by several metrics.
As it relates to EMD, a uniformly upward increase in average credit quality since the late 1990s has led to significantly lower sovereign spreads for hard-currency debt.
Despite a spike in sovereign spreads during the global financial crisis, spreads have remained relatively stable since then and less susceptible to contagion from non-EM events.
In the case of local currency debt, the average maturity of issuance has doubled since 2000, which is an indicator of more seasoned markets.
The total outstanding debt in emerging markets has risen to approximately US$14 trillion, based on data from the Bank of International Settlements (BIS), mostly due to the expansion of the local currency market.
In comparison, the market capitalisation of the Barclays Capital Global Aggregate Bond Index – a proxy for the global investment-grade bond market – was approximately US$45 trillion as of June 2014.
This evidences that the size of the asset class is now significant.
Although EMD markets have reached a considerable size, this does not directly correspond to the size of the actual tradable market, given that many EM assets have restricted access, low liquidity, or are subject to regulatory controls.
We believe the total size of the tradable market matters for most overseas investors and stands at nearly US$3 trillion midway through 2014.
Investors should closely follow policy developments that could improve access to these assets, in our view, as the future supply of EMD assets relates to the growth of the tradable market.
Investor appetite for EMD assets has not only increased significantly in the past decade, but has accelerated over the past five years, especially in mutual funds where the annualised five-year growth rate for cumulative flows is close to 60 per cent.
Despite this impressive growth, allocation to EMD by large institutional investors is still small as a percentage of total assets.
Estimates from recent pension fund surveys in the US, the UK and continental Europe indicate that on average only 3.2 per cent of portfolio assets are allocated to emerging-market bonds.
This is a potential opportunity for further growth in the asset class and also appears to be an incentive for EMD markets to develop improved access and operations, as global institutional investors seek more exposure to these investments.
In our view, the EMD opportunity set and global investor interest in the asset class are only just beginning to develop.
We believe that within this burgeoning asset class there are broad structural sources of inefficiency and long-term cyclical trends in emerging markets that create a wide range of alpha opportunities to exploit.
As returns can be divergent between countries and/or debt types, our experience has taught us that in-depth fundamental analysis and a holistic approach helps to improve returns for portfolios investing in a single category of emerging market debt.
As the investment opportunity continues to develop, we believe an active management approach is well-suited to capture the value in the EMD asset class.
Arif Joshi is a portfolio manager of the Lazard Emerging Markets Total Return Debt Fund.
