In Russ Koesterich's most recent Market Perspectives report, he made the case for emerging market (EM) bonds in today's investment portfolio, stating that several factors make this asset class more attractive than it was just five years ago. Competitive yields, improving fundamentals and cheap currencies have helped to make this a more attractive investment. But perhaps the biggest story in emerging market debt has been an improvement in credit quality -- both in an absolute sense and, perhaps more interestingly, relative to bonds from developed markets.
This last point comes as a surprise to most investors. When you picture bonds from emerging economies, visions of defaults and currency devaluations are likely dancing in your head. What you may not know is that the credit quality of this asset class has steadily improved over the past twenty years. Many EM debt issuers have learned lessons from the past and as a result, have developed sound fiscal policies which have resulted in more stable economies and, in many cases, investment grade credit ratings (see below). Today over 60% of the emerging market bond universe is rated BBB or above.
Emerging Market Bonds: Global Market Capitalization by Credit Buckets
So what's causing this improvement in credit risk among emerging market issuers? There are four key drivers:
- Better fiscal management. In other words, living within one's means. For bond issuers this means raising revenue and reducing spending. According to data from the latest IMF World Economic Outlook, emerging economies' fiscal revenues as a percentage of GDP increased from the high teens in the 1980s to slightly above 30% today.
- Stronger balance sheets. It may surprise you to know that compared to the developed markets, emerging markets have been deleveraging. Prior to the financial crisis, the average level of developed market gross government debt as a percentage of GDP was 74%; today, it stands at 110% -- a number that, if not quickly reversed, could lead to a secular slowdown in growth. In contrast, EM countries were already repairing balance sheets heading into the financial crisis and have maintained stable debt-to-GDP levels since then (see below).Click to enlarge
- Funded pension systems. Rather than pay-as-you-go systems (such as the Social Security program we have in the U.S.), many emerging market countries have self-funded retirement systems. So while the U.S. fiscal position may begin to deteriorate by the end of the decade as the burden of an aging population pushes up pension and healthcare spending, most EM countries have limited this risk by reforming their pension systems.
- Rise of local currency bond markets. Because emerging markets have been issuing more obligations in their local currencies, rather than a hard currency like USD, they have a reduced reliance on external funding. While we still see active issuance in USD EM bonds, stronger EM issuers have lessened the potential for a currency crisis by matching their income and funding currencies through the issuance of local currency debt.
Composition of Emerging Market Debt
Meanwhile, in addition to the improving credit quality of this asset class, it's also become increasingly available to investors in the form of ETFs. Before the first EM bond ETF was launched in 2007, it was virtually impossible for an individual investor to get their hands on these securities. And at the time, not many wanted to. But as interest in EM debt has grown, the category's assets under management have swelled to $13.6 billion, and there are now 16 EM bond ETFs to choose from ranging from broad to more country specific exposures.
Even with the improved risk profile, it’s still important to understand that emerging market debt is a volatile asset class compared to more traditional bond investments. Investors should consider their personal risk profile and portfolio objectives when choosing how much to invest, if at all. More conservative investors may want to avoid significant exposure to the category, while aggressive investors with high-income goals could allocate more (Koesterich advocates 10-30% of a fixed income portfolio). If EM bonds are right for you, the increasing number of EM bond ETFs can give you the opportunity to invest in a previously difficult to access market.
 G7 countries include France, Germany, Italy, Japan, Canada, the United States and United Kingdom.
 Credit ratings are assigned by Nationally Recognized Statistical Rating Organizations based on assessment of the credit worthiness of the underlying bond issuers. AAA bonds (investment grade) carry the highest credit rating. Below investment-grade is represented by a rating of BB and below. Ratings and portfolio credit quality may change over time. Unrated securities do not necessarily indicate low quality.
Sources: JP Morgan, Bloomberg, IMF.
Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.