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Fixed Income
EM debt: Extending the reach of income portfolios
Harry Phinney
Fixed Income Investment Director
Joseph Dowd
Senior Product Specialist

In today’s low-rate environment, investors looking for income need to use every tool in their toolbox. For many in the U.S., the first inclination is to turn to high-yield corporate bonds. Though these bonds can be an important part of an income-focused portfolio, we believe that investors should also consider an allocation to emerging markets (EM) debt.


The evolving breadth and depth of emerging markets provide active investors with significant relative value opportunities. The idiosyncratic nature of the asset class also makes it a natural complement to largely U.S.-centric high-yield corporate bonds. It can provide the twin benefits of income and diversification in an income-seeking bond portfolio.


As we look at the market today, EM debt should benefit from the ongoing post-pandemic global economic recovery. Additional support may come from stable to rising commodity prices, growing external surpluses, low developed-market interest rates and predictable monetary policies alongside an abundance of global liquidity. The predominant risk to this constructive scenario is if elevated levels of inflation persist for an extended period, forcing major central banks to remove monetary accommodation at a faster pace relative to market expectations.


That said, we still believe valuations and yields in many areas of EM debt are reasonably compelling and are likely to benefit from a supportive economic backdrop. As long as we continue to see even modest global economic growth rates, we believe that there is value to be found across all segments of EM debt, including U.S. dollar-denominated bonds (investment-grade, higher yielding sovereigns, EM corporate bonds) as well as local currency debt. Each of these segments has characteristics that can serve as important building blocks of a well-rounded portfolio.


We recognize that many institutional investors prefer to make deliberate and discrete allocations to the dollar-denominated and local currency bond segments of the EM debt universe. As such, we will separately discuss the merits and current relative value opportunities in both.


Current opportunities in hard currency bonds


Looking first at hard currency sovereign EM debt (which is predominately issued in U.S. dollars), as shown in the chart below, yields for the sub-investment-grade segment of these bonds are comparably higher than U.S. high-yield corporate issuers, providing investors with an additional and differentiated source of potential income generation.


Furthermore, the ratings composition of the two sectors is also similar, with more than 80% of both segments now rated either BB or B. The market for these bonds is significant, constituting 39% of the $1.3 trillion J.P. Morgan EMBI Global Index. Currently, some countries where we find value include Angola, Egypt and the Dominican Republic.


Emerging markets corporate bonds are one of the fastest growing sectors of the asset class, currently valued at $1.3 trillion. Valuations indicate these bonds may be particularly attractive across a variety of below-investment-grade (BB/Ba and below) issuers. Like their sovereign counterparts, these bonds offer favorable yield characteristics and opportunities for geographic diversification relative to U.S. high-yield corporates. Additionally, more than half of the issuers are rated BB/Ba, thus exhibiting a similar credit ratings profile to their U.S. counterparts.


EM yields compare favorably to U.S. corporate high yield

Line chart showing the spread between hard currency high-yield emerging markets sovereign debt represented by the J.P. Morgan EMBI Global Diversified HY Blended Index, emerging markets local currency debt represented by the J.P. Morgan Government Bond Index-Emerging Markets Global Diversified, EM high-yield corporate bonds represented by the J.P. Morgan CEMBI Broad Diversified High Yield Index and high-yield U.S. corporate debt represented by the Bloomberg Barclays Capital U.S. Corporate High Yield 2% Issuer Capped Index from 2016 until August 2021. Since 2020, emerging markets high-yield bonds have yielded in excess of 200 basis points above high-yield U.S. corporate debt. After spiking above 9% in March 2020, U.S. corporate high-yield bond yields have fallen below 5% as of August. Local currency emerging markets debt yields lagged behind U.S. corporates from late 2018 until early 2021 but have offered marginally higher yields in recent months.

Source: Bloomberg Index Services Ltd., J.P. Morgan. Yields reflect yield to maturity. U.S. high-yield corporate bonds reflect Bloomberg U.S. High Yield Corporate 2% Issuer Capped Index, EM local currency sovereign bonds reflect J.P. Morgan Government Bond Index – Emerging Markets Global Diversified, EM hard currency high-yield sovereign bonds reflect J.P. Morgan EMBI Global Diversified High Yield Blended Index, EM high-yield corporate bonds reflect J.P. Morgan CEMBI Broad Diversified High Yield Index. Data as of August 31, 2021.

Select local issuers offer attractive yield and diversification benefits


As the chart above also shows, local currency EM sovereign bond yields compare favorably to U.S. high-yield, while offering both low correlation and currency diversification benefits to an overall income-focused portfolio.


The overall local currency bond universe, as defined by the J.P. Morgan Government Bond Index - EM Global Diversified, is investment-grade rated with an average rating of BBB. Local currency EM bonds have also historically been less correlated to equity indexes like the S&P 500 than hard currency EM sovereign and U.S. high-yield corporate bonds. (Correlation is a statistical term describing the degree to which two numbers move in coordination with one another.)


EM local currency bonds have provided correlation benefits

This line chart shows monthly three-year rolling correlation data to the S&P 500 total return index for EM local currency bonds represented by the J.P. Morgan Government Bond Index – Emerging Markets Global Diversified Total Return Index (USD) and U.S. corporate high-yield bonds represented by the Bloomberg U.S. Corporate High Yield Total Return Index (USD). EM local currency bonds have displayed significantly lower correlation to the S&P 500 since 2016.

Source: Morningstar Direct. Reflects monthly three-year rolling correlation relative to the S&P 500 total return index. EM local currency sovereign bonds reflect J.P. Morgan Government Bond Index – EM Global Diversified index, U.S. high-yield corporate bonds reflect Bloomberg U.S. Corporate High Yield Total Return Index.

We laid out our case for local currency emerging markets bonds earlier this year, and our view has not fundamentally changed.


While currency-related volatility is often a concern for some investors, we believe the overall benefits of U.S. dollar diversification and income outweigh those concerns.


There are a variety of factors that influence the valuation of the U.S. dollar, making it difficult to predict its exact cyclical inflection point. That said, valuations suggest that the U.S. dollar is currently overvalued relative to a broad basket of both developed and emerging markets currencies with a variety of potential catalysts to the downside, including:


 

  • An ongoing synchronized rebound in global growth that is supportive of export economies
  • Prolonged monetary policy accommodation from developed market central banks
  • The Fed’s shift toward average inflation targeting that has allowed inflation to run above target
  • A sharp rebound in commodity prices

Local currency debt has added value in periods of U.S. dollar weakness

Bar chart compares the cumulative returns for local currency emerging markets debt and U.S. dollar emerging markets debt during periods of U.S. dollar weakness, as represented by periods when the Bloomberg Dollar Spot Index declined by more than 10%. In five different periods since the mid-2000s, both local currency and U.S. dollar emerging markets debt significantly outpaced the spot price of the dollar. Additionally, local currency emerging markets debt outpaced the results of U.S. dollar emerging markets debt, with the one exception from March 2020 to December 2020, when dollar-denominated emerging markets debt outpaced local currency debt by 40 basis points.

Source: Bloomberg Index Services Ltd., J.P. Morgan. U.S. dollar-denominated emerging markets debt represented by the J.P. Morgan EMBI Global Diversified Index; local currency emerging markets debt represented by the J.P. Morgan Government Bond Index – Emerging Markets Global Diversified Index. Reflects cumulative results during periods when the Bloomberg Dollar Spot Index declined by more than 10%. Data as of March 31, 2021.

Within local markets, some examples of higher quality issuers that we currently hold include China, Mexico, Peru and Malaysia.


The bottom line


In a world where income is hard to come by, investors may consider broadening their view beyond U.S.-centric high-yield corporate bonds to include a strategic allocation to emerging markets debt. Some investors may prefer discrete exposures to the U.S. dollar and/or local currency denominated segments of the market; and in the context of the current market environment, we believe there are attractive risk-adjusted opportunities in both of these areas.


That said, we also believe that a blended approach allows investors to maximize relative value potential across the asset class given the unique characteristics and distinct drivers of return inherent to each of these segments.



Harry Phinney is a fixed income investment director with 15 years of industry experience as of 12/31/20. He holds an MBA in international business from Northeastern University, a master's degree in applied statistics and financial mathematics from Columbia University and a bachelor's degree in international political economy from Northeastern University. 

Joseph B. Dowd is a senior product specialist with 11 years of industry experience (as of 12/31/20). He holds an MBA from the Marshall School of Business at the University of Southern California and a bachelor's degree in political science from University of California, Riverside. 


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Higher yielding, higher risk bonds can fluctuate in price more than investment-grade bonds, so investors should maintain a long-term perspective.

 

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The J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified High Yield Blended Index is an emerging markets debt benchmark that tracks total returns for high-yield U.S. dollar-denominated bonds issued by emerging markets sovereign and quasi-sovereign entities. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.

 

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