Interest in emerging markets debt (EMD) has soared in the past few years, with investors responding to sustained rapid growth and solid fiscal metrics in this group of economies. But which type of EMD makes most sense for institutional investors? EMD, after all, consists of not one but three separate asset classes: dollar-denominated government debt, typically referred to as “sovereign debt”; dollar-denominated EM corporate debt; and local-currency government debt. During the past decade or so, each has done well, generating fairly high returns and producing attractive Sharpe ratios. Their track records suggest that any of the three could fit comfortably within most investors’ portfolios.
The characteristics of the three asset classes do differ, however, and each will likely suit particular objectives. The EMD asset classes vary not so much in terms of their geographical composition or their credit quality but rather in the type of exposure to global markets that they imply. Buying local currency debt means taking exposure to EM foreign-exchange (FX) trends, while the USD-based assets—as with all unhedged spread product—include a U.S. Treasury component. The two types of debt are likely to perform relatively well under different states of the world. When global growth is strong, EM FX will tend to appreciate, and Treasury yields will tend to rise. These factors favor local-currency debt. During less boomy periods, Treasury yields will likely decline and EM FX will remain stable or sell off, tilting the scales toward dollar-based assets. Indeed, between 2003 and 2007, when the first set of conditions applied, local-currency debt outperformed USD-denominated EMD. Between 2008 and 2011, when the second type of environment dominated, USD-based sovereign debt outperformed.
Over a lengthy time horizon of, say, five years, local-currency debt seems likely to outperform again. Global growth will likely accelerate gradually in coming years after the disappointments of the early part of the recovery; EM FX is coming off a significant sell-off in 2011 and remains well below its pre-crisis peak; and the very low level of Treasury yields makes a rise over a five-year period more likely than a decline. Investors willing to add beta to their portfolios and contemplate long holding period might thus favor investments in local-currency EMD. The EM FX appreciation path, though, will not necessarily proceed smoothly, and any particular year could bring a sell-off. Moreover, the current global monetary policy atmosphere means that a Treasury sell-off may lie some distance own the road. Investors with a shorter horizon, and those less enthusiastic about adding beta to their portfolios, might thus favor USD-denominated sovereign debt.
While USD-denominated EM corporate debt trailed the other two EMD categories in returns during both 2003-2007 and 2008-2011 (though it underperformed local-currency debt only very slightly during the latter period), it possesses two virtues that make it an interesting option as at least part of an EMD portfolio. First, it is the most “Asian” of the three EMD asset classes, providing more exposure to the fastest-growing part of the global economy and one in which many investors still have only modest holdings.
Second, in contrast with sovereign debt, its spread over Treasuries currently stands wide to its medium-term average. Investors with a focus on value thus may find EM corporate more appealing than the two government-based EMD assets.
The chart below presents the main characteristics of each asset class within the EMD category. In each case, we use the relevant JPMorgan index as a proxy for the underlying asset class. We chose the ones that we believe to be most used as benchmarks by asset managers: the EMBI Global Diversified (EMBIG) for dollar-based external debt; the CEMBI Broad Diversified (CEMBI) for EM corporates; and the GBI-EM Global Diversified (GBI-EM) for local-currency government debt. At the moment (using figures as of January 31, 2012), the GBIEM offers, by a slim margin, the highest yield among the three EMD asset classes. This has not always been the case, but the very low level of Treasury yields has dragged down the overall yield on the two spread product classes, even though spread levels are either in line with (EMBIG) or wider than (CEMBI) medium-term averages. Its higher yield comes despite a shorter duration and a marginally higher average credit rating than are the case for the USD-based indices.
To summarize, each of the three EMD asset classes has delivered strong returns over time and deserves consideration. If the global economy grows strongly in coming years, local-currency government debt will likely outperform, thanks to its foreign-exchange component. Hard-currency sovereign debt, a lower-beta investment, is likely to outperform in a softer global growth environment. EM corporate debt, which is currently attractively valued, offers more direct exposure to EM Asia than the two government-debt EMD categories.
Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.
