Now that the great interest rate reset has revitalised fixed income as an asset class, the higher-return potential of emerging market corporate debt is particularly compelling.
Our Emerging Markets Debt Stars strategy successfully navigated a challenging environment in 2023. The strategy returned 7.5% in US dollar terms, driven primarily by income yield. It was a year of uncertainty for global growth and geopolitics, but one that was dominated by central banks’ hawkish interest rate policy to control persistent inflation. The continuation of this ‘great interest rate reset’ meant that bonds finally offered investors, starved of yields for so long, attractive levels of income. We believe that a revitalised fixed-income asset class now has the potential to generate returns not seen since before the 2008 Financial Crisis.
Company fundamentals matter most
When it comes to emerging market debt, many investors think of sovereign debt (bonds issued by governments of emerging market countries). It is easy to see why. Sovereign debt accounts for the lion’s share of the emerging debt universe. However, the risk/return profile of emerging market sovereign debt is very different to that of emerging market corporate debt. The risk of sovereign bond defaults rests on the economic health of the country, while the risk of corporate debt is primarily dependent on the quality of a company’s fundamentals.
The difference is key. Debt issued by companies in less developed areas has an altogether different risk profile. It is why the perceived risks of emerging market debt are in our view greater than the actual risks associated with the underlying corporates. Local risks, including economic, social or political are more than offset by the underlying fundamentals of quality companies. Investing in hard currency emerging market debt (US dollar, euro, sterling) lowers currency-exchange risk. Additionally, investing in corporates enables us to gain exposure to specific themes we identify as opportunities.
Over the past two years, the perfect storm of rising inflation and higher interest rates has seen many developing countries grappling with worsening debt and meeting their bond obligations. In late 2022 Ghana defaulted on its external debt as its economic crisis deepened, while Argentina’s balance of payments deficit worsened further.
Sovereigns must also contend with social, geopolitical and conflict risks. The ongoing Russian conflict, for example, still weighs on Ukraine. President Recep Tayyip Erdogan’s re-election last May caused a sudden change in Turkey’s monetary policy that had considerable ramifications for its bond market.
Reviewing the performance of our emerging debt strategy, many companies based in countries facing economic and political turmoil were our biggest success stories of 2023.