Investing in emerging markets debt

In a series of research papers, we discuss the investment case for emerging markets (EM). In this paper, we look at EM debt, whose importance to global investors has grown rapidly over the past two decades.

The performance drivers of EM debt

Emerging markets debt refers to a number of complex asset classes that can behave quite differently over various time horizons. The main subsets or sectors within EM debt include:

• EM hard currency sovereign debt (EMD): Issued by governments of EM countries but denominated in the currencies of developed market (DM) countries; most commonly, the U.S. dollar.
• EM hard currency corporate debt (EMC): Issued by companies operating in EM countries and is predominantly U.S. dollar denominated.
• EM local currency sovereign debt (EML): Government‑related bonds issued in the domestic currency of the issuing country.

In this paper, we introduce a framework to think about the return and risk characteristics of these three EM debt assets through a quantitative lens. This framework allows us to attribute the performance of the EM debt assets into three related, but distinct, drivers:

1. Coupon: The regular interest paid on the debt by the issuer over time.
2. Price: The returns from price appreciation/depreciation of the bond based on mark‑to‑market interest rate and credit spread movements. Since the bond price responds to the rates environment, we will also refer to it as rates sensitivity in this paper.
3. Currency: The impact of currency fluctuations on the value of both the principal and the coupons of an EM bond.

EMD: Emerging markets hard currency sovereign debt

Our historical analysis covers the period from January 1, 2003, through December 31, 2024, with all returns calculated in U.S. dollars based on the J.P. Morgan EMBI Global Diversified Composite Index. Figure 1 shows that over this period, the overwhelming majority of EM hard currency sovereign debt returns could be attributed to the coupon component. Over the full period, the coupon accounted for 98% of the total annualized return of 6.4%.

Price returns were positive in the early years from 2002 to 2007, forming a significant share of the total return. Broadly constant from 2010 onward, the price return declined in terms of its relative importance to the total return, which was increasingly driven by the coupon.

As global rates rose under the influence of the Fed’s monetary tightening from 2021 onward, the cumulative price return from EM hard currency sovereign debt fell close to zero. By definition, the currency impact is zero, since the bonds are denominated in U.S. dollars.

Turning to volatility, it was the price component, which reflects both interest rate and credit risks, that accounted for most of the volatility in the return from EM hard currency sovereign debt (with a volatility contribution of 9.0% versus just 0.4% for the coupon).

The bar chart in Figure 2 shows clearly how the impact of price on return declined steadily as the investment horizon increased. While price was clearly a large risk factor for EM hard currency sovereign debt over shorter periods, such as one month or a year, its impact on total returns decreased as the investment horizon was extended from one year to 10 years. So by holding EM hard currency sovereign debt for longer, time could help to mitigate a large portion of return volatility.

EMC: Emerging markets hard currency corporate debt

Figures 3 and 4 show the return and risk profile of EM hard currency corporate debt. The bulk of EM hard currency corporate debt’s total returns could be attributed to the coupon component. The price component, which reflects both interest rate and credit risks, accounted for most of the volatility.

Price was clearly a significant risk factor for EM hard currency corporate debt over shorter‑term periods. As with EM hard currency sovereign debt, the impact of price on total returns fell sharply as the investment horizon was lengthened from one year to 10 years. By holding EM hard currency corporate debt for longer, time was able to mitigate a large portion of total return volatility.

Compared with EM hard currency sovereign debt, over January 2003 to December 2024 EM hard currency corporate debt delivered a lower annual total return (5.9% versus 6.4%) with less volatility (7.4% versus 8.9%).

EML: Emerging markets local currency sovereign debt

Figure 5 reveals that compared with EM hard currency bonds, EM local currency sovereign debt delivered a lower total annualized return over the period of 4.9%, which corresponded to two decades of strong U.S. dollar performance. With the added FX dimension, volatility was naturally significantly higher than for hard currency EM debt at 11.6% annualized.

Over the period, the bulk of EM local currency sovereign debt total returns could be attributed to the coupon component. Currency exposure was the main return detractor and risk contributor for EM local currency debt, having delivered mostly negative returns post 2010 when the strong dollar phase began. A conviction of how EM currencies will perform relative to the U.S. dollar is required to make asset allocation decisions into and out of this asset class.

Framework for EM debt manager return decomposition

In the last section of the paper, we propose a framework to decompose the excess returns of an external EM debt manager in order to answer two key questions:

1. Does this manager take more or less risk with the coupon, price, or currency component relative to its benchmark?
2. How much of this manager’s excess returns can be attributed to idiosyncratic alpha rather than beta to the three components of market returns?

When analyzing an external EM debt manager’s style, investors should gauge whether the manager takes more or less risk with the coupon, currency, and rates components of total returns. The component sensitivities can help investors understand each manager’s style and develop an informed decision of which type of market environment the manager is expected to outperform or underperform.

Modeling EM debt return component sensitivities

Modeling return sensitivities can be handled with a standard ordinary least squares (OLS) regression framework. By definition, the benchmark return components for coupon, currency, and rates must have a regression coefficient (beta) of one to the benchmark total returns. We can therefore regress the same benchmark components onto a manager’s total returns in order to understand the manager’s investment style.

An illustrative example appears in Figure 7. This manager combines a relatively cautious approach to currency (β (FX) = 0.70) than to coupon (β (Coupon) = 1.40) and rates (β (Rates) = 1.40). With an average annual return of 1.5% versus the benchmark’s 1.0%, the manager achieved an excess return of 50 basis points, a strong performance. However, once the returns are adjusted for different component sensitivities, “true” alpha from bond selection is only 20 basis points.

The manager’s style preferences are portrayed graphically in the triangular graphic (radar chart) to the right of the table in Figure 7. The light blue area shows the return sensitivities of the chosen manager to the three return components. If a vertex point of the blue triangle appears inside the dark gray of the benchmark triangle, then the manager is less sensitive to that component of total returns than the benchmark. But if the vertex lies within the light gray area, the manager is more sensitive than the benchmark to that return component.

Figure 8 takes our example further by showing how different EM debt manager types might be expected to perform under different market environments. For instance, the top row represents a manager who is neutral versus the benchmark on currency but geared with respect to both price return and coupon. That manager is expected to generate higher returns from the coupon component versus the benchmark index over time and outperform when interest rates abate.

Conclusion

In the first half of the paper, we show that the major share of EM debt total returns accrues from the coupon rather than from the price return or currency changes. As the investment horizon extends, the share of total return contribution by coupon grows and the volatility of the EM debt asset classes falls sharply, increasing their attractiveness for global investors.

In the second part of the paper, we consider the drivers of EM debt returns from the point of view of an investor who is evaluating potential external investment managers. In this case, it is important to understand how much return component exposure an external manager is taking in their pursuit of alpha. We set up a framework for estimating the “style” bias of each manager in terms of coupon, price, and currency risk relative to the benchmark. This framework facilitates a comparison of the “true” alpha of each external manager.

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