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FOR EMERGING MARKETS DEBT
Emerging markets debt has, over the past decade, attracted growing attention from investors as a higher-yielding alternative. Investors had initially insisted on hard cur- rency emerging markets bonds but, increasingly, they have added local currency bonds to their portfolios.
The bond markets of the emerging markets have grown substantially over the past decade, and the investment universe has become broader. More and more countries, currencies, and issuers have been added, liquidity has increased substantially, investors’ diversification opportunities have been considerably expanded, and the quality of the issuers has improved.
When establishing an emerging markets debt (EMD) mandate, many questions have to be answered. Passive or active management? Hard or local currencies? Government and corporate bonds? Is a “blend” concept, which invests across investment options, the right solution? Or perhaps a total return strategy independent of index benchmarks? How to deal with the diverse currency risk?
J.P. Morgan emerging markets debt indices are the most widely followed among asset managers in the industry. Since most investors in emerging markets debt will have some exposure to these indices, it is important to understand how they are constructed as well as their potential benefits and drawbacks.
Among the most common representatives of the various EMD markets are the J.P. Morgan EMBI Global Diversified Index for government bonds in hard currencies, the J.P. Morgan CEMBI Broad Diversified Index for corporate bonds in hard currencies, and the J.P. Morgan GBI-EM Global Diversified Index for government bonds in local currencies.1
In historical terms, hard currency investments— as listed in the J.P. Morgan EMBI Global Diversified Index—received the greatest attention from investors. This is mainly because it had a large investable universe, the currency risk was relatively easy to manage for many investors, and the index is well diversified across 63 countries and 127 issuers.
For some years the strongest market growth has been in the J.P. Morgan CEMBI Broad Diversified Index for hard currency corporate bonds and the J.P. Morgan GBI-EM Global Diversified Index for local currency government bonds. These markets are often viewed as the “actual” emerging markets bond markets for investors and active managers over the long term, because investors can potentially exploit illiquidity and inefficiency premiums.
Currency management can play an important role for non-US investors. All emerging markets debt indices are listed in base form in US dollars, so investors must decide whether to hedge currency exposure.
The Global Bond Market
Political discussion in recent years has focused on the topics of “saving” and “austerity.” In Europe—but also in the United States, Japan, and many emerging markets—the global financial crisis appears to have inspired some rethinking, and many politicians have increasingly taken the position that “you can only spend what you’ve brought in.”
Some commentators argue that not only the state, but the banks, some enterprises, and private consump- tion as well, must deleverage. Other critics have complained that the austerity of recent years endan- gers growth, jobs, and prosperity. From this debate, it is reasonable to assume that the world bond markets have not grown in some time as less and less debt is being created.2
However, the opposite has actually occurred. Worldwide debt and the volume of the world bond markets have continued to rise since the financial market crisis, albeit at muted rates. The world remains a debt economy and the economic actors remain dependent upon new loans. The inventories of finan- cial assets—especially bonds—have risen steadily and reached a new high at the end of 2014 (Exhibit 1).3
A large portion of the assets on the financial markets is either not relevant or not accessible to the typical investor. When limiting the bond market to those bonds that are publicly accessible and liquid enough to be listed in bond index benchmarks (e.g., indices of Bank of America Merrill Lynch), the assets under consideration shrink considerably, but are still huge and have grown explosively in the last decade. The largest portion of the overall volume of the $56.0 trillion (liquid) world bond market consists of (local) government bonds ($33.3 trillion), followed by corporate bonds ($7.9 trillion), and secured bonds (covered bonds or asset backed securities ($6.8 trillion)) (Exhibit 2).4
Exhibit 1 Despite Talk of Austerity, Financial Assets Have Continued to Grow Since 2008
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E
Nonsecuritized Loans Outstanding
Securitized Loans Outstanding
Nonfinancial Corporate Bonds Outstanding
Financial Institutions Bonds Outstanding
Public Debt Securities Outstanding
Stock Market Capitalization
14 14 15 14
55 56 58 60 60
50 54 54 57 61
26 26 27 27 30
33 37 42
As of 31 December 2014
Source: BIS, Deutsche Bank, Haver, McKinsey Global Institute estimates
Exhibit 2 The World Bond Market Has Grown Significantly in the Past Decade
Face Value of Index-Qualifying Debt (USD Billion)
High Grade Corporates
High Yield Corporates
As of 31 December 2014
Source: BofA Merrill Lynch Indices
Emerging Markets Debt
At the end of 2014, the $6 trillion (liquid) emerging markets bond market made up slightly more than 10% of the global bond market, but has grown substantially more than the global bond market in recent years.
This is true, in particular, of the “non-sovereigns” segment—corporate bonds. On the positive side, the strong market growth means a larger universe and better diversification opportunities for investors than in the past, but it also implies that the debt of many emerging markets, coming from an extremely low basis, has steadily risen (Exhibit 3).
Exhibit 3 The Growth of the Emerging Markets Bond Market Has Been Strong
Outstanding Debt (USD face value in millions) YOY Growth Rate
Sovereign (%) Total (%)
2004 804,891 331,628 176,457 N/A 1,312,976 — — — — —
2005 1,110,352 374,565 214,086 N/A 1,699,003 38.0 12.9 21.3 N/A 29.4
2006 1,338,553 383,271 277,837 N/A 1,999,660 20.6 2.3 29.8 N/A 17.7
2007 1,604,257 401,087 344,152 N/A 2,349,496 19.9 4.6 23.9 N/A 17.5
2008 1,719,223 386,239 348,855 N/A 2,454,317 7.2 -3.7 1.4 N/A 4.5
2009 2,035,395 435,402 423,569 N/A 2,894,366 18.4 12.7 21.4 N/A 17.9
2010 2,421,852 488,516 565,513 N/A 3,475,881 19.0 12.2 33.5 N/A 20.1
2011 2,770,891 524,454 679,862 N/A 3,975,207 14.4 7.4 20.2 N/A 14.4
2012 3,190,093 576,903 889,602 148,181 4,804,778 15.1 10.0 30.9 N/A 20.9
2013 3,579,600 610,594 1,101,836 161,313 5,453,342 12.2 5.8 23.9 8.9 13.5
2014 3,921,508 603,969 1,253,949 205,370 5,984,796 9.6 -1.1 13.8 27.3 9.7
As of 31 December 2014
Source: BofA Merrill Lynch Bond Indices
For the investor (as well as the issuer) in emerging markets, the distinction between “external debt” and “local debt” is of central importance. External debt comprises the bonds of issuers of emerging markets that have been issued in hard currencies—the US dollar, euro, British pound, or Japanese yen. About 75% of these bonds are listed in US dollars; for this reason, this is sometimes referred to as the dollar segment of emerging markets bonds. On the other hand, “local debt” consists of bonds that the issuer issues in its own currency.
If, for example, Brazil finances a bond that is denomi- nated in US dollars, this bond is external (sovereign) debt. If Brazil issues a bond in its own currency, the real, the bond is part of local (sovereign) debt. This logic applies not only to country issuers but compa- nies as well. If Petrobras, domiciled in Brazil, issues a bond in US dollars, this bond is part of external (non- sovereign) debt. If it finances itself in Brazilian reals, the bond is part of local (non-sovereign) debt.
External debt, or “emerging markets hard currency bonds,” was the dominant asset class for decades since the first debt was issued in the 1960s. Due to their underdevelopment and weakness, most emerging countries were not able to issue bonds in their own currency, but instead had to issue bonds in currencies of the developed world.