Emerging market debt (EMD) offers high yields and solid fundamentals of many emerging market economies. Higher bond returns typically come with increased risks when compared to U.S. Treasury and corporate debt issues. Over the last decade, emerging market issues have become less reactive to political stability or external obligations issues. Credit quality of many EMD bond issues is increasing. That’s good news for EMD traders.
Investment grade dollar-denominated sovereign debt of emerging markets governments is sought after by Western investors in search of higher yields and liquidity as U.S. bond yields remain near historical lows. Outstanding sovereign issues represent a total market of about USD 18.5 trillion. When institutional demand for these issues outstrips the supply of bonds, prices of EMD sovereign paper go up and yields go down.
As Federal Reserve watchers wait for an uptick in U.S. corporate and Treasury bond interest rates, emerging debt issuers continue to price debt at tantalizing rates. In this article, we discuss emerging market debt and consider the potential risk-reward relationship compared to other fixed income assets.
What Is Emerging Market Debt?
The four largest emerging or developing economies are Brazil, Russia, India, and China (the BRIC countries). The next largest emerging debt markets are Mexico, Turkey, Indonesia, and Saudi Arabia.
Emerging market debt is a financial term used to describe bonds issued by emerging or developing country economies. Nonetheless, an emerging country doesn’t always have an emerging debt market.
Like the U.S. debt market, emerging market bonds may be securitized by loans or other assets and issued into local and international financial markets. Issues are sold in all different sizes as well. Institutional investors in search of high yield emerging market bonds typically buy size from larger issues. This is due to the fact that larger bond issues usually offer more liquidity as buyers and sellers trade bonds.
If you’re planning to trade emerging market debt, you’re probably looking for capital appreciation and total return by investing in or buying and selling EMD bonds issued by emerging markets governments, related entities, and high credit corporations located in these counties. USD-denominated issues are frequently preferred but some attractive issues are priced in local currencies.
According to Moody’s Investor Service analyst Elena Duggar, (2015) the growth of local currency sovereign bonds is an essential component in reducing emerging market debt risks.
To identify the right issues for your portfolio, combine top-down and bottom-up analyses. Country analysis is part of the top-down analysis. Choose individual bond issues using bottom-up fundamental analysis. Use the following 10 tips to profit from emerging markets debt.
10 Tips for Profiting from Emerging Markets Debt
1. Select investment grade EMD bonds or bond indexes
This is beneficial because you will hedge issues and reduce trading risk.
2. Consider the impact of currency on EMD holdings
According to the Emerging Markets Traders Association, about two-thirds of EMD trading occurs in local currency issued paper. Local currency issuance helps the country to avoid exchange-rate risk. As a result, issuing paper in the local currency helps the issuer to develop the local market and avoid any currency-related risk.
3. Take a view about local currency vs. the U.S. dollar
Local currency-denominated EMD issues may diversify a fixed-income portfolio as they add new risk and volatility. Exchange rate shifts may affect EMD investments’ value. For instance, if the USD is trading poorly against the EMD local currency, bond price rises. If the USD is strong against the local currency, the bond price declines.
4. Crystallize your position about interest rates in the U.S. market
Dollar-denominated EMD issues trade with U.S. interest rates and policy rates. If interest rates rise in the U.S., the EMD position is likely to react more strongly than U.S. Treasuries and investment grade corporate bonds.
5. Consider volatility
Emerging markets debt can be volatile. If you’re a trader in search of volatile assets, emerging markets bonds may be right for you. Study individual EMD issues before deciding to trade them.
6. Keep perspective about emerging markets grow rates
For example, China’s recent growth may be slowing down compared to its recent history. When compared to the growth Europe, Japan, and U.S. debt markets, China’s relative strength is positive. China is also one of the world’s largest debt markets.
7. Compare GDP rates
In developed markets, government debt is 90 percent plus of GDP. In contrast, EMD public sector debt has remained stable. Look for 40 percent of GDP or less.
8. Consider the dollar sovereign index to U.S
Treasury yields. Compare it to the USD corporate index. Buy EMD corporate bonds when the corporate index is higher than the sovereign index.
9. Buy or trade high quality corporate emerging debt
EMD corporate issues may offer higher credit ratings than sovereign debt. These issues can also offer better returns.
10. Hedge high volatility
Some EMD paper trades like stocks. Therefore, add MSCI Emerging Markets Index (MXEF) if you’re developing an active EMD trading strategy.
Trading emerging market debt is a potentially lucrative strategy for those who can assume the risk. If you’re new to EMD bonds, learn the different types of emerging market debt; these include Brady bonds, USD-denominated local paper, sovereign or corporate Eurobonds, debt options, warrants, and also loans.
Use top-down analysis to determine the issuer’s ability (and willingness) to repay investors. Include macroeconomic analysis to evaluate the economic structure, indicators, and ratios of emerging market debt issues. Always factor in a political risk assessment when buying or selling emerging market bonds. This is because the government’s structure and current economic policy affect EMD issues’ market valuation.
In conclusion, trading emerging market debt is likely to provide advantageous mispricings, special situations, and market dislocations. EMD securities are often subject to multiple risks, including credit and rate risk. Issuers of EMD bonds may fail to repay interest or principal. Like all debt securities, EMD bonds appreciate or depreciate according to demand, or interest rate changes. Consequently, buying longer-term emerging market bonds may increase portfolio volatility.
Trading emerging market debt involves risks such as market risk, currency, accounting, political, or economic risk. If trading high-yield emerging market debt appeals to you, realize that lower credit high-yield securities are more credit and interest-rate sensitive than investment grade bonds.