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The importance of EMD in diversified fixed income portfolios

Emerging market debt has grown in sophistication and significance over the past few decades and has earned its status as a major asset class.

31/01/2023
yield

Authors

John Mensack
Investment Director, Fixed Income

 

(The first in a periodic series of reports on emerging market debt.) 

Emerging market debt (EMD) has grown in sophistication and significance over the past few decades and, by any measure, has earned its status as a major asset class. EMD spans multiple continents and 70+ countries as well as a wide array of investment opportunities in both hard and local currencies and from sovereign and corporate issuers. Impressively, many emerging markets (EMs) now exhibit fully developed yield curves with significantly improved liquidity and price efficiency.  

There is a significant amount of EMD investment grade credit from which to choose and corporate issuers include global powerhouses in sectors as diverse as e-commerce, electronic vehicles, artificial intelligence, protein and food exports, and green energy. With a market capitalization of $1 trillion, EM corporate debt is commensurate with US high yield (HY) at $1.3 trillion.1  

And yet we see evidence that EMD does not represent a weighting within professionally managed portfolios commensurate with either its highly developed nature or market capitalization. Surprisingly, other asset classes that are smaller in market capitalization capture higher portfolio allocations. 

The purpose of this report and ones to come is to acquaint investors with this asset class and explore the details behind why investors should pay attention to it. This is especially important as we navigate a new world that is no longer indifferent to the level of real interest rates and fully cognizant of the downside of developed market (DM) central bank largesse over the past several years. These conditions create an environment that we believe is well-suited to EMD. 

This first report serves as a primer on EMs in general and the EMD asset class itself, while subsequent reports will tackle related subjects that are more granular in nature.  

EM Characteristics 

EMs represent:

EMD-202302-1-3r

EMD Characteristics

Too large to ignore

Figure 4_built from scratch

Competitively sized relative to other commonly held asset classes

Figure 5_built from scratch

A generous amount of investment grade (IG) credit

Figure 6_built from scratch

Correlation of US banking sector bonds vs banking sector bonds in various EMs

EMD-202302-7

Source: JP Morgan, Bloomberg, and BofA.

The table below summarizes characteristics of the key segments of the asset class, as measured by the most appropriate market index. While each segment carries promise, it can also carry downside risk, which is why a diversified approach to this asset class is often the best.

EMD-202302-8

Source: JP Morgan.

In our next report, we will explore how EMD aligns with the realities of the regime shift that is underway in both macroeconomic policy and the financial markets. Specifically, Schroders has identified five key macro themes below that are likely to influence portfolios over the next several years. 

  • Central banks will prioritize controlling inflation over growth.
  • Governments will respond with more active fiscal policy.
  • The new world order will challenge globalization.
  • Companies will respond to higher costs by investing in technology.
  • The response to climate change is accelerating.


1JP Morgan, Bloomberg.

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Authors

John Mensack
Investment Director, Fixed Income

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