Jai Jacob: The view on emerging market debt

Jai Jacob 160 byline

Emerging markets continue to exhibit better growth and lower leverage relative to their developed market counterparts. Economic expansion in the region remains positive, though it has slowed since 2010. Even at more muted levels, GDP growth in emerging countries is well ahead of growth rates in the developed world. Similarly, relative to developed countries, emerging-market debt-to-GDP ratios remain significantly lower.

From an emerging-market debt perspective, external debt as represented by the JP Morgan EMBI Global Diversified index has performed particularly well up over 14 per cent year to date. Local debt, as measured by the JP Morgan GBI-EM Global Diversified index, has risen approximately 12 per cent year-to-date. Emerging market corporate bonds have also performed well thus far this year, rising 13.5 per cent according to the JP Morgan CEMBI Diversified index.
Within external debt (namely US dollar-denominated), roughly 62 per cent of countries are now investment grade; as such, they tend to trade with very high correlations (80 per cent to 95 per cent) to US Treasuries. Although we may see spread compression in these credits, total returns ought to be overwhelmed by the scourge of rising US Treasury yields. We expect flat to negative returns for external investment grade debt. In contrast, the 38 per cent of external debt that is non-investment grade offers very compelling carry and spread compression opportunities, without the aforementioned link to the US Treasury curve. There are numerous investment opportunities in this area of the sovereign external debt market that offer very attractive yields between 7 per cent to 12 per cent and expected spread compression between 50 bps to 150 bps over the medium term.

Within the corporate debt market, which is almost exclusively US dollar-denominated, both investment-grade and high-yielding bonds offer significant spread pickup relative to developed-market companies and emerging market sovereign curves. When doing a like-for like balance sheet and cash flow comparison of these credits to their peers, one can typically find corporate investments in emerging markets that trade at a yield premium of 100 bps to 200 bps relative to global peers. We anticipate returns in the high single-digits to low double-digits in both high-yield sovereign debt and corporate bonds.

For local emerging market debt, many yield curves are already flat as a result of easing monetary policies that have been in place for the better part of a year. Investors pick up little premium by extending out on these curves and increasing exposure to longer maturity bonds; furthermore, some local emerging market curves that are more developed exhibit high correlations to US Treasuries.

Given these realities, we expect limited real yield compression in local emerging-market debt (as an asset class) and are simply left with the running yield at the short end of these curves, which currently averages 5 per cent to 6 per cent. We believe that the next stage of the rally will be predicated on economic data that bears out expectations of improvement. We would caution, however, that while anticipated global easing can certainly sustain a market rally over the next few months, we must witness real sustained economic improvement into the end of the year in order to avoid another giveback on valuations, similar to previous years.

Jai Jacob is portfolio manager at Lazard Asset Management