Finding income in emerging market debt

Hard currency emerging market debt (EMD) offers a balanced mix of income and resilience, with stable growth, contained inflation and a favourable ratings trajectory pointing to continued fundamental strength. While selectivity remains key—and country and credit differentiation matters—the asset class appears to be well positioned to deliver attractive risk-adjusted returns.

A key support is on the demand side, where tight developed market (DM) spreads and declining yields are pushing investors towards emerging markets. High all-in yields have been the main draw to fixed income markets over recent years. The resultant strong demand has led to spreads compressing across many fixed income sectors. With DM central banks cutting rates and little spread premium on offer, declining DM yields will likely push investors to seek out new opportunities to maintain the yields they have become used to. We believe many will turn to EMD, which continues to offer a premium and is supported by positive flows. The high level of carry, combined with strong fundamentals, means that carry-to-volatility is far more appealing in emerging markets than in developed markets.

This positive demand backdrop for EMD occurs at a time when we expect more repayments of debt, through coupon and capital repayments of bonds, than issuance across both sovereign and corporate markets. Most of the issuance we have seen so far this year has been investment grade and we expect this trend to continue as high yield issuers hold off refinancing until rates come down or look to other sources for refinancing.

Within EMD, we find the structure of the corporate market provides credit investors with opportunities for diversification vs. US high yield. Spread tightening in the US has left the majority of US high yield securities yielding between 4.5% and 6%. By comparison, the emerging market (EM) corporate high yield market is yielding between 6% and 7.5%, while also offering a greater number of opportunities. These valuations provide technical support for crossover investors moving to EM corporates.

We also see a spread premium pickup in EM sovereigns vs. DM credit. EM investment grade spreads have already tightened to similar levels as their DM equivalents, and BB rated sovereign securities now trade at only a small premium of 10 basis points (bps) compared to their US equivalents. However, opportunities can still be found in selective areas of the EM sovereign markets, such as in single B securities, which offer a premium of around 65-70 bps over US securities with the same rating.

Against this positive backdrop, we find that a barbell strategy can add value. This strategy combines exposure to longer duration, high quality, high yield (BB-rated) bonds that have the potential to be upgraded to investment grade, such as Paraguay and Morocco, with shorter duration high carry (B rated) opportunities, such as Nigeria and Egypt.