Read this article to understand:
- Why investors should consider an allocation to EMD HC within fixed income
- The key growth drivers including resilience, diversification benefits and favourable macroeconomic trends
- How our investment approach balances alpha generation with prudent risk management
Historically viewed as a tactical allocation during periods of market volatility, emerging-market debt (EMD) has often been underutilised in fixed-income portfolios. Yet, the rationale for a strategic long-term allocation to EMD hard-currency (HC) sovereign debt is more persuasive than ever.
Emerging markets (EMs) constitute a formidable share of the global economic landscape, representing 87 per cent of the world’s nations, 85 per cent of the global population, 50 per cent of global GDP in 2023, and two-thirds of global GDP growth over the ten years from 2013 to 2023.1,2 Despite this, EMD only accounts for 26 per cent of global fixed income assets, which we believe represents a missed opportunity for investors.
Moreover, the EMD market has seen substantial growth in issuers' diversification. In 1991, only four EM countries issued external debt. By 2024, that number has expanded to nearly 80, enhancing EMD’s resilience by spreading risk more evenly across a diverse range of economies.
Additionally, EM hard-currency sovereign debt has over a long period provided stronger risk-adjusted returns than global sovereign and investment-grade corporate debt from developed countries (see Figure 1).
Figure 1: Risk and returns of various asset classes over 20 years (per cent)
Past performance is not a reliable indicator of future performance.
Note: Historical returns and standard deviations for the period from December 31, 2002 to October 31, 2024. All returns and standard deviations are annualised. EMD HC (sovereign) is represented by the J.P. Morgan EMBI Global Composite Index; EMD HC (corporate) is represented by the J.P. Morgan Corporate EMBI Broad Diversified Composite Index; EMD local currency (sovereign) is represented by the J.P. Morgan GBI-EM Global Diversified Composite Index Unhedged USD; High yield bonds are represented by the Bloomberg Global High Yield Corporate Total Return Index Unhedged USD; commodities are represented by the S&P GSCI Total Return Index; global IG is represented by the Bloomberg Global Agg Corporate Total Return Index Value Unhedged USD; cash is represented by the S&P U.S. Treasury Bill 3-6 Month Index; global equities are represented by the MSCI World Index; EM equities are represented by the MSCI Emerging Markets Index USD; US Treasuries are represented by the Bloomberg US Long Treasury Total Return Index Value Unhedged; global developed market sovereign bonds (USD) are represented by the Bloomberg Global Agg Treasuries Total Return Index Value Unhedged USD.
Source: Aviva Investors, Bloomberg. Data as of October 31, 2024.
Over recent decades, numerous EMs have also implemented rigorous macroeconomic reforms to build resilience. Policies designed to mitigate external shocks and enhance credit quality have strengthened these economies. For example, Turkey has implemented monetary tightening and fiscal discipline to curb inflation and stabilise its currency, while Côte d’Ivoire has prioritised infrastructure development to boost economic stability. Egypt and Nigeria have increased foreign exchange flexibility, while Brazil has adopted inflation-targeting and fiscal responsibility measures. In 2024, nearly half of investment-grade (IG) sovereigns within EMs are rated AA to A.
Consider EM HC sovereign debt’s total return performance from 1993 to 2023: it outperformed US high yield by approximatively 50 per cent, according to latest research by Bank of America. In particular, over nearly three decades, this asset class has outperformed other major fixed income markets, achieving a cumulative return of over 900 per cent. This far exceeds the average cumulative returns of around 300 per cent for US Treasuries and 700 per cent for US high-yield bonds over the same period. Over the period, annualised returns for EMD HC stood at 7.5 per cent, compared to 6.7 per cent for the US high-yield market.3
Today, EMD offers exposure to a diverse spectrum of economies, from large economies like China and Brazil to fast-growing nations in Southeast Asia and sub-Saharan Africa, such as Indonesia, the Philippines, Cote d’Ivoire and Senegal. While each country’s economic profile differs, many share positive characteristics, including stronger growth prospects, lower debt levels, and favourable demographics compared to developed markets.
A resilient asset class
While the structural argument for EMD HC is compelling, assessing current market conditions is equally important. In recent years, many EM issuers have displayed resilience in the face of geopolitical and macroeconomic headwinds. This can be attributed to proactive measures taken by EM central banks, such as early and aggressive interest-rate hikes to combat inflation.
Since 2022, major EM nations like Brazil, Mexico, India, Indonesia and Kenya have improved their fiscal balances and managed inflationary pressures effectively. These favourable macroeconomic conditions, coupled with moderate growth expectations, create an attractive environment for their bonds. Additionally, countries such as Mexico and Indonesia have maintained prudent fiscal policies, strengthening investor confidence despite global uncertainties.
Major EM nations have improved their fiscal balances and managed inflationary pressures effectively since 2022
However, while these nations have acted prudently, they may still need to rebuild financial buffers that were drawn down during previous economic pressures, such as the COVID-19 pandemic. The International Monetary Fund (IMF) baseline projections for EM and global growth suggest we are likely to see more of the same – slow but steady growth with controlled inflation, allowing these countries to rebuild those buffers and improve balances.4
The diversification of EM economies has also played a pivotal role in their stability. Commodity exporters like Chile and Peru have benefitted from high commodity prices, while nations such as Colomba and Kenya have driven growth through robust manufacturing, technology and service sectors. These trends are expected to persist in the coming months. Moreover, many EM countries are showing significant fundamental improvements, particularly in the high-yield segment. Nonetheless, thorough bottom-up assessments remain essential when evaluating these investments.
From a valuation standpoint, recent strength in hard currency spreads reflects a growing recognition of EM’s enhanced fundamentals in a supportive external environment. Even during turbulent summer markets, EMD hard currency demonstrated resilience, with spreads tightening despite US Treasury weakness. Although EM investment-grade spreads remain tight compared to US Treasuries, this is justified by robust fundamentals. With all-in yields at the highest levels in a decade (see Figure 2), the present moment offers a compelling opportunity to lock in these elevated rates. Technical factors further support this outlook, with anticipated inflows and reduced net issuance in 2024 boosting the positive momentum for EMD HC.
Figure 2: EMD all-in yields remain high (per cent)
Past performance is not a reliable indicator of future performance.
Note: The Markit CDX Emerging Markets Index (“CDX EM” or the “Index”) is composed of fifteen sovereign reference entities that trade in the CDS market.
Source: Aviva Investors, Bloomberg. Data as of June 30, 2024.
Where should investors look for opportunities?
The opportunity set can be broadly divided into two key groups: post-restructuring stories and reform stories.
The first category includes Zambia, Ghana and Sri Lanka. Zambia, emerging from its own restructuring, remains a country with evolving opportunities. In Ghana and Sri Lanka, upcoming elections later this year could be transformative. If new administrations come to power and demonstrate a commitment to fiscal consolidation and engagement with the IMF, these markets could become particularly attractive.
Sri Lanka recently issued macro-linked bonds as part of its debt restructuring
Sri Lanka recently issued macro-linked bonds as part of its debt restructuring, tying repayments to its economic performance through 2027 under an IMF-supported programme. Macro-linked bonds are a form of state-contingent debt where payments adjust based on macroeconomic indicators like GDP growth. For Sri Lanka, repayments vary with both nominal and real GDP performance – higher payments are required if the economy grows, while payments decrease if it underperforms. These bonds aim to improve debt sustainability by aligning payments with Sri Lanka’s economic capacity, help attract investors by reducing emerging market risks and incentivise stronger economic performance. However, given Sri Lanka’s recent economic instability due to previous mismanagement, these bonds carry risks, particularly if growth targets aren’t met, which could hinder recovery and investor confidence.
In the second category, Argentina, Ecuador and Nigeria stand out. In Argentina, Javier Milei’s determined efforts to curb inflation and rein in public spending signal a promising shift in economic policy. Ecuador, should Daniel Noboa win in the February elections and continue with IMF-backed reform, could once again yield strong returns. Despite the ongoing protests in Nigeria, we believe removing the fuel subsidy and implementing measures to enhance foreign exchange flexibility are crucial steps that should gradually bolster reserve capacity and improve economic stability because they reduce fiscal pressures and support investor confidence.
Beyond these are also enticing opportunities in IG and crossover credits, supported by high all-in yields (see Figure 2). Risks present opportunity. For example, despite the geopolitical risks in the region with Israel, Gaza and Iran, the Middle East continues to offer excess return relative to its solid underlying fundamentals, with growing opportunities arising from quasi-sovereign issuances. Ivory Coast benefits from robust economic growth, a commitment to fiscal prudence, and membership in a currency union that reduces default risk. The country has also demonstrated a strong track record of collaborating with the IMF.
The IMF highlights two primary threats to growth: tariffs and the impact of high financing costs
While our base case anticipates a transition from resilience to strength, it’s crucial to identify where the risks lie and which countries may be vulnerable. The IMF highlights two primary threats to growth: tariffs and the impact of high financing costs. Elevated financing costs – driven by persistently high Treasury yields and potentially slower monetary policy easing – pose several challenges for emerging markets. These include higher interest expenses that hinder fiscal consolidation efforts, increased competition with the US for capital leading to reduced inflows and complicating reserve accumulation, and a diminished capacity to lower interest rates. Collectively, these factors could dampen growth prospects and further impede fiscal stabilisation. Although this scenario is not our base case, recognising which nations are at risk and which possess the ability and commitment to pursue fiscal consolidation and reform will be crucial in identifying the winners of the next economic cycle.
For instance, Kenya could find further fiscal consolidation a challenge, against the risk of further social protests, while Panama and the Dominican Republic will likely opt for slow fiscal consolidation to avoid protests. And Ecuador and Argentina both need to regain access to the Eurobond market. This could be put at jeopardy if rates remain at elevated levels.
Our approach to EMD
At Aviva Investors, our two decades of expertise in managing EMD enable us to deliver strong risk-adjusted returns for our clients. Our approach is designed to generate alpha consistently across market cycles, with a focus on sustained outperformance. Although past performance is not indicative of future returns, the Aviva Investors Emerging Markets Bond strategy, investing predominantly in EMD sovereign bonds, has historically generated alpha regardless of the direction of spreads (see Figure 3).
Figure 3: Performance of the Aviva Investors Emerging Markets Bond strategy versus spread (per cent/bps)
Past performance is not a reliable indicator of future performance.
Note: Aviva Investors EMD Hard Currency Sovereign USD composite (inception date January 1, 2004) and J.P. Morgan EMBI Global Index.
Source: Aviva Investors, Bloomberg, eVestment. Data as of September 30, 2024.
We believe EMD’s alpha potential lies in the breadth and diversity of this under-researched and often underreported asset class. Yet many EMD investment approaches fail to capture this potential due to inherent structural biases. These often result in an overexposure to higher-risk market segments, a heavy reliance on conventional risk metrics, and an inability to distinguish between beta and alpha drivers in portfolio construction.
Our unbiased approach to EMD avoids these common pitfalls. Rather than focusing only on higher-yielding riskier segments, we explore opportunities across the investable universe. This allows us to build portfolios free from pre-set biases, generating alpha that is independent of high-yield and investment-grade spread differentials.
EMD represents a critical, yet underappreciated, component of global fixed-income portfolios
We focus on the most attractive opportunities, irrespective of credit rating, with a deep understanding of EM-specific risks. By recognising the limitations of traditional risk metrics, we construct portfolios that prioritise capital preservation while consistently outperforming benchmarks (although past performance does not guarantee future results). Additionally, effective liquidity management is central to our approach, which can help our portfolios remain resilient across market conditions. This rigorous and comprehensive approach delivers a smoother, more stable return profile, strengthening the case for making EMD hard currency a structural allocation in fixed-income portfolios.
EMD represents a critical, yet underappreciated, component of global fixed-income portfolios. As the asset class grows in significance, driven by stronger fundamentals and favourable macroeconomic conditions, it offers investors a powerful opportunity for diversification and yield enhancement. By investing in EM hard currency sovereign debt with an unbiased approach, investors can position their portfolio to capitalise on the resilience and long-term growth potential of emerging markets.
