Emerging-markets debt continues to benefit from strong fundamentals from both a macroeconomics and public-finance perspective. It has also experienced steady demand, particularly given its small size (3.5%) relative to the scale of global fixed-income assets. The sustained evolution of this asset class presents Canadian plan sponsors with an expanding range of opportunities for relatively high income and broad diversification across credit, foreign-exchange and interest-rate risks.
An important milestone in the development of emerging-markets debt was the introduction by J.P. Morgan of its first emerging-markets fixed-income index at the end of 1994. This roughly coincided with the advent of important structural reforms across much of the developing world, which led to burgeoning economic growth and nascent fixed-income markets, most notably in Asia and parts of Latin America. While not immune to economic and financial cycles, many emerging-market economies have subsequently generated strong growth.
Expanding supply
The current market value of tradable emerging-markets bonds is approximately US$3.3 trillion, compared to the tradable global fixed-income market, which stands at approximately US$100 trillion. The emerging-markets bond market consists of three main sectors: sovereign external debt, sovereign domestic debt, and quasi-sovereign and private external debt. In addition, emerging-markets corporate domestic bonds (which are dominated by Chinese CNY corporate bonds) could double this market size, but remain broadly inaccessible to foreign capital at this time. New and evolving emerging-markets fixed-income assets include structured finance (e.g., securitization of receivables), infrastructure bonds, municipal debt, interest-rate swaps, credit-linked notes and forward-rate agreements.
The supply of emerging-markets debt is expanding rapidly, not a surprising trend given the strong global demand for higher-yielding fixed-income products, as investors deal with suppressed yields across the developed world. There were US$430 billion of emerging-markets foreign bonds issued in 2012 and approximately US$130 billion to the end of March 2013, according to Bank of America-Merrill Lynch.
Along with higher income, a key attraction for investors has been the superior fundamentals of many emerging markets. The gross domestic product (GDP) of developed economies grew, on average, 1.3% in 2012, while emerging markets grew 5.3%. The debt picture is also noteworthy, with general government indebtedness in developed economies running at an average 105.5% of GDP at the end of 2011 versus just 37% of GDP in emerging markets.
On a budget basis, developed markets are running an average fiscal deficit of -6.6% of GDP and -4.8% of GDP of primary deficit. Contrast this to emerging markets, which run an average fiscal deficit of -1.8% of GDP and 0.2% of GDP of primary surplus.
Understanding the risks
Despite compelling factors, risks remain. Mispricing in the primary market is intrinsic to emerging-market debt and is typically caused by excess demand over supply. Since the beginning of 2012, fund flows are net positive into emerging-markets debt and lately net negative into emerging-markets equity funds. Another risk is inflation, which varies widely across emerging markets, from mildly deflationary (Georgia, Ukraine) to hyperinflation (Venezuela, Belarus and Argentina). Political risk can also be a factor, as recent revolutions in the Middle East and political transitions in Venezuela and North Korea have shown. Additional risks now include the potential high level of indebtedness in China’s “shadow” financial sector.
Accessing the extensive and evolving prospects within emerging-market debt requires expertise in the different types of risk and opportunities associated with the asset class and the ability to dynamically hedge portfolios against exogenous tail risks.
Claire Husson-Citanna is portfolio manager and emerging market debt research analyst, Franklin Templeton Fixed Income Group