As emerging countries see buoyant growth, improved fiscal policies, and increasingly more affluent populations, fundamentals, local and frontier markets, and corporate debt are transforming. Prudent fiscal policies and global demand for commodities have driven strong growth and allowed emerging countries to improve their balance sheets over the last economic cycle. Thus, we believe the asset allocation according to historical investing norms in emerging market debt relative to developed markets requires some discussion. The change in composition of government debt issuance and the rise of corporate debt issuance are reshaping the emerging debt opportunity set.
One driver of emerging debt opportunities is an increase in locally issued debt. Emerging debt investors traditionally have invested in the more abundant U.S. dollar-denominated government bonds when compared with locally issued debt. However, emerging countries, having survived a few downturns, have learned that borrowing in local currency gives governments greater monetary control without foreign intervention. Hence the increase in supply of local currency-issued debt instruments provides a greater selection for emerging debt investors. As these markets are expected to grow faster than developed markets, the self-reinforcing local issuance should continue to offer an increasing array of investment possibilities that may be funded by reducing allocation to the rapidly deteriorating debt inventory of developed markets.
From a dollar-denominated or hard currency sovereign investment standpoint, frontier markets offer another opportunity in what will likely be the future source of alpha for emerging market investors—especially those with the analytical capabilities and capacity to enter into these markets—as these relatively less liquid markets have correlation benefits to an emerging debt portfolio. As such, we foresee assets shifting through incremental investments into frontier countries, currently the only growth area of hard currency issuance.
Inflation-linked securities versus nominal securities also provide opportunities for return in the emerging markets. To help attract international investors, favourable changes in maturing tax codes welcome foreign investment directly into local bond markets. With expectations of significant rate hikes in select emerging local markets, there is an opening to capture appreciation in inflation-linked instruments.
Most interesting, in Mike Conelius’s opinion, are the opportunities resulting from the evolution and expansion of corporate debt in emerging markets. For years, governments borrowed far too much at high interest rates, crowding out the private sector. The local corporate sector today is relatively under-levered, and in fact, many of these corporations are considered investment grade. Investments in corporate debt can be an excellent way to capture domestic growth in these markets. Emerging banks, for example, have fairly high capital ratios and are relatively attractive; although they tend to be rated lower than their developed peers, they are much less stressed by leverage. Banks aside, emerging market corporations are raising more capital locally to fund moves into the turf of developed market corporations. Mike believes, to benefit from the evolution of these corporations emerging investors should consider fixed income investments in select emerging market corporations.
Emerging debt markets rival the size of the U.S. high yield market, albeit not in liquidity (though liquidity is improving). Emerging market portfolio managers now able to focus investment decisions on sectors, names, and company managements can lend directly to a company and dis-intermediate local banks. Even though emerging debt, both sovereign and corporate are extremely highly correlated, over time this is expected to change and emerging market investing likely will receive even greater attention from institutional investors this year.
Mike Conelius is portfolio manager, Emerging Markets Bond Strategy with T. Rowe Price.