Emerging markets have become more attractive in the last few months. However, many investors still see emerging debt as a highly risky asset class. They have clearly not taken the time to look at the changes taking place in emerging-market countries: for example, they appear not to be aware that almost 65% of emerging corporate debt denominated in dollars (the benchmark currency in this market) is investment grade (IG).
In addition, IG emerging corporate bonds in US dollars show lower volatility than equivalent bonds in the US market. As a result, Sharpe ratios – a measure of risk-adjusted returns – in the IG emerging corporate bond market are higher than those on IG US bonds. Investors looking for IG corporate bond investments should therefore not think in geographical terms, ruling out emerging markets straight away, but focus more on issuer ratings. An emerging-market issuer with a BBB rating is no riskier than a US or European BBB-rated bond if you look at the default rate.
Insurance companies have already made some progress in this direction as a result of the new Solvency 2 regulatory framework. The regulator does not impose any investment constraints based on the issuing company's geographical origin. Both German and Brazilian BBB-rated bonds are subject to the same prudential calculation rules. This sensible approach allows investors to take a holistic view of risk.
Growth differentials are moving back in emerging markets' favour
The economic situation in emerging-market countries has improved considerably since last year. In 2014 and 2015, fundamentals were poor in these markets.
An economic slowdown caused partly by a decline in commodity prices, weakening currencies relative to the dollar and an increase in local interest rates meant that emerging markets held little appeal for investors.
Since the summer of 2016, however, there has been a major turnaround. Growth is accelerating again, and the growth differential between emerging-market and developed countries is widening again in favour of the former. Risk arising from the uncertain situation in the Chinese economy has faded substantially. Some emerging currencies have gained against the weaker dollar, but the phenomenon is not widespread. The strong euro has pushed up the currencies of emerging Central and Eastern European countries that tend to track the euro. The Mexican peso, which had fallen sharply after Donald Trump was elected in November 2016, is gradually regaining its strength.
In conclusion, emerging-market fundamentals are likely to continue improving, attracting new money into funds specialising in those markets. 2017 has already brought a significant upturn in investment flows. Opportunities include dollar-denominated emerging debt, which allows investors to take positions on the US yield curve, now that there is greater visibility on the US Federal Reserve's monetary policy. Even including the cost of currency hedging, these bonds are delivering a higher return than investments on the euro yield curve.
Denis Girault
Head of Emerging Markets Fixed Income