Unprecedented policy support from central banks and governments around the world helped stabilize markets in the face of Covid-19 in 2020, supporting a resumption of economic activity and contributing to a historic decline in bond yields. This year concerns that demand-focused fiscal stimulus may lead to an overheating of economies have caused bond yields to rise. But while rates have broken out of their 2020 ranges, high levels of government debt across developed markets, paired with systemically low rates of inflation, are likely to prolong the low-rate environment.
Investors are thus grappling with heightened interest rate volatility in what is still a low-yield environment by historical standards. This means they must reevaluate their core fixed income allocations to ensure that they keep delivering both stability and income throughout a market cycle.
We believe that in this environment, certain areas of emerging market (EM) debt have a place in core fixed income allocations, on par with another portfolio staple: US dollar investment grade bonds. Specifically, we view the $2.5 trillion universe1 of investment grade debt issued by EM corporate and sovereign issuers in a reserve currency, typically US dollars, as a compelling opportunity set for core fixed income investors.
The first point of comparison between investment grade (IG) hard-currency EM debt and US core fixed income is naturally yield – specifically, the potential for EM debt to help solve the challenge of historically low bond yields. Over the past decade, hard-currency investment grade EM debt has typically offered investors roughly 1.10% of excess yield over investment grade US credit, with surprising consistency.2
Source: J.P. Morgan, Bloomberg Barclays, and PineBridge Investments as of 09 March 2021. EM Corp. is J.P. Morgan CEMBI Broad Div. IG, EM Sov. is J.P. Morgan EMBI Global Div. IG, US Credit is Bloomberg Barclays US Credit. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.
The consistent relationship between yields on EM investment grade debt and US IG credit is important for investors looking to enhance core fixed income portfolio yield without introducing meaningful deviation from internal benchmarks. It is also indicative of a similar relationship in credit spreads. Over the past decade, US investment grade credit spreads have occupied a 183 basis point (bp) range, while the ranges for investment grade EM corporate debt and EM sovereign debt have been 237 bps and 188 bps, respectively.3 Given the similarities in yield and spread, it’s not surprising to observe strong relationships with total returns as well: investment grade EM corporate and sovereign debt have shown 0.88 and 0.85 correlations to US credit since 2010,3 respectively.
Source: J.P. Morgan, Bloomberg Barclays, and PineBridge Investments as of 09 March 2021. EM Corp. is J.P. Morgan CEMBI Broad Div. IG, EM Sov. is J.P. Morgan EMBI Global Div. IG, US Credit is Bloomberg Barclays US Credit. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.
With consistently higher carry and similar trends in credit spreads, investors might assume that investment grade EM debt markets have delivered higher total returns in exchange for a similar increase in volatility. However, while both investment grade corporate and sovereign debt have generated higher total returns than US credit over the past decade, EM corporates have actually done so with lower annualized volatility.
Source: J.P. Morgan, Bloomberg Barclays, and PineBridge Investments as of 28 February 2021. EM Corp. is J.P. Morgan CEMBI Broad Div. IG, EM Sov. is J.P. Morgan EMBI Global Div. IG, US Credit is Bloomberg Barclays US Credit. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change. Past performance is not indicative of future results.
The growth of EM debt over the past decade has expanded the universe of investable securities, while the credit quality of the external debt market overall has remained roughly 55%-65% investment grade.4 That growth and consistent quality have resulted in rising index inclusion of EM debt, in turn allowing actively managed core FI portfolios to allocate more to EM debt given its presence in portfolio benchmarks. However, this approach tends to limit the benefits EM debt can deliver to core FI portfolios, given that most core fixed income indices remain materially underweight EM debt relative to the size of the investable universe.
While emerging markets represent more than 40% of the global economy and EM debt accounts for just over 22% of overall global bond volumes, EM accounts for only 14% of the Bloomberg Barclays Global Aggregate Index, and the majority is denominated in local currencies.5 For investors who typically allocate to core fixed income portfolios benchmarked against reserve currencies, the EM exposure tends to be much smaller, as EM accounts for only a little over 5% of the Bloomberg Barclays US Credit Index.6
Equally important are the characteristics of the EM exposure within core fixed income benchmarks relative to the overall universe available to investors. Here we find a compelling argument in favor of dedicated EM debt exposure as opposed to asset allocation within the context of a portfolio benchmarked against the US credit. Exposure in the Bloomberg Barclays US Credit Index is concentrated in Latin America,7 and valuations come up short of what can be found in dedicated EM indices, particularly the EM corporate investment grade index.8
Source: J.P. Morgan, Bloomberg Barclays, and PineBridge Investments as of 09 March 2021. EM Corp. is J.P. Morgan CEMBI Broad Div. IG, EM Sov. is J.P. Morgan EMBI Global Div. IG, US Credit is Bloomberg Barclays US Credit. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.
Beyond the potential relative value advantage to be found in a dedicated EM debt allocation, the regional differences in composition can have a significant impact on risk and return potential. Asia, which represents nearly half of the investment grade EM corporate market, is a key contributor to the overall stability of this market, due in large part to support from a robust local investor base.
The role of Asia as a risk reducer has never been more relevant than during the height of Covid-related volatility in March 2020. Up until the 23 March 2020, when the Fed announced it would begin purchases of investment grade US corporate bonds, EM investment grade corporate credit spreads were more resilient than US credit spreads, widening 237 basis points compared to the US market’s 257.9 Asia, for its part, was central to this stability, with spreads on Asian investment grade corporate bonds widening just 150 basis points in the month up to 23 March.10
Source: J.P. Morgan, Bloomberg Barclays, and PineBridge Investments as of 31 December 2020. EM Corp. is J.P. Morgan CEMBI Broad Div. IG, EM Sov. is J.P. Morgan EMBI Global Div. IG, US Credit is Bloomberg Barclays US Credit. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.
As investors consider the benefits of a dedicated allocation to investment grade EM debt in their core fixed income portfolios, they may be encouraged by supportive fundamentals. From a sovereign perspective, EM debt-to-GDP is roughly half that carried by developed market (DM) sovereigns. Moreover, EM corporates have traditionally carried less leverage on their balance sheets than their DM counterparts, and many EM management teams have experience managing through economic crises.
The fundamental stability of EM corporate debt has historically contributed to lower rates of fallen angels and high yield defaults than US corporate debt. Although headline fallen angel rates were higher for EM corporates in 2020, more than half of the year’s total came from the downgrade of Pemex.11 Moreover, many of the remaining fallen angels resulted from sovereign downgrades and the sovereign rating ceiling that the agencies place on EM corporate issuers, rather than a true deterioration of creditworthiness.
Source: J.P. Morgan, S&P, and PineBridge Investments as of 31 December 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, estimates, forecasts and forward-looking statements presented herein are valid only as of the date of this presentation and are subject to change.
While the collapse of global bond yields may have been abrupt in 2020, we have long believed that the growth and maturation of EM debt markets would inevitably lead to an increased allocation to EM debt within core FI portfolios. Although the rationale for such consideration may be widespread, the complexity and breadth of the market mean it’s critical for investors to carefully consider their investment objectives and the optimal means by which EM debt can help meet those objectives.
For more PineBridge insights on emerging market fixed income, see “How EM Debt Investors Can Surf an Inflation Surprise.”
1 Source: J.P. Morgan and PineBridge as of 31 December 2020
2 Source: J.P. Morgan and PineBridge as of 09 March 2021
3 Source: J.P. Morgan, Bloomberg Barclays and PineBridge as of 09 March 2021
4 Source: J.P. Morgan as of 31 December 2020
5 Source: IMF, Bloomberg Barclays as of 31 December 2020
6 Source: Bloomberg Barclays as of 31 December 2020
7 Source: ibid
8 J.P. Morgan CEMBI Broad Diversified
9 Source: J.P. Morgan, Bloomberg Barclays as of 31 October 2020
10 Source: Ibid
11 Any reference to security is not intended to be a recommendation to buy or sell a security or an indication of the holdings of any portfolio or an indication of performance for the subject company/issuer
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any re-publication or sharing of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.
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