Fixed Income

Why EM Debt Can Continue to Shine

October 18, 2019
EM debt reveals its strengths as a growth asset.

Key Points

  • Emerging markets (EM) debt delivered higher returns and shown relative stability compared to its equity counterpart over the long term.
  • EM debt has less exposure to some of the main sources of volatility and capital loss in emerging markets, such as local currency volatility.
  • While emerging market equities offer attractive idiosyncratic opportunities, we see reasons why EM debt could continue to deliver better risk-adjusted returns over the longer term.

History shows that emerging markets (EM) debt can offer not just stability, but also can potentially deliver higher absolute returns than its equity counterpart. This might fly in the face of conventional thinking, which typically considers fixed income investments as safer and more stable and equity investments as the best sources of higher growth and absolute return potential. However, when it comes to EM, we believe both debt and equity can be thought of as growth assets.

EM debt’s relative stability coupled with historically high income have helped it to deliver noticeably higher cumulative returns than EM equity. Therefore, while both asset classes contain many attractive opportunities for active managers, we think investors should consider EM hard currency debt as the best potential compensation for risk in the EM universe.

The reasons for EM debt’s historical outperformance include the following:

  • Hard currency bonds are less exposed to local currency exchange fluctuations, which have been a significant driver of EM volatility and capital loss. Higher inflation rates and persistently negative current account balances continue to pressure EM currency markets. Although many EM countries displayed fundamental economic improvements in recent years, part of this process resulted in many countries opening their economies and allowing currencies to float freely rather than maintaining capital controls or currency pegs. In many places, this has resulted in a longer‑term depreciation of local currencies even as countries may have been implementing favorable reforms. Overall, EM currencies have depreciated roughly 20% against the U.S. dollar since 2003.1

    Furthermore, the past seven years in the wake of the global financial crisis saw an extended period of U.S. dollar strength. The relative weakness and higher volatility of EM currencies eroded equity market returns, whereas EM hard currency debt markets were not directly affected.

  • EM debt also has a smaller corporate sector exposure relative to EM equity, which is entirely composed of corporate assets. While many EM companies displayed strong growth during the past 10 years, the corporate sector remains riskier and has higher volatility compared with EM sovereign bonds. By nature, EM equity does not contain any exposure to sovereign assets, so the corporate sector has a larger influence on performance.

  • EM debt has generated a significant portion of its returns from coupon payments, which are a more stable component of returns than capital appreciation. The coupon rate in EM has historically been between 5% and 7%.2 Equity markets do not have a comparable source of regular returns, with dividends at 2.9%.3

…fixed income should be thought of as a primary source of potential long‑term returns.

In our view, the key takeaway is that fixed income should be thought of as a primary source of potential long‑term returns. That is not to say that investors should discount EM equity, which still offers many opportunities for investors to gain exposure to individual corporate names. At times, EM equity can also outperform EM debt and other asset classes. However, over the long term, we see reasons why EM debt can continue to deliver better risk‑adjusted returns. Despite meaningful improvement and reform processes, many countries are still in the midst of structural adjustments. While there may be periods where local currencies outperform on an idiosyncratic basis, the overall weakness and volatility of local currency markets will likely continue over longer time frames.

In our view, investors searching for the best risk‑adjusted returns should continue to look actively at both equity and fixed income names. Overall, though, investors should remember that EM debt is not just a more stable option, but also a driver of potential growth.

1Source: J.P. Morgan (see Additional Disclosures). As of August 30, 2019.
2Source: J.P. Morgan Emerging Market Bond Index Global (see Additional Disclosures). January 1, 2013 to September 30, 2019.
3Source: MSCI Emerging Markets Index (see Additional Disclosures). As of September 30, 2019.

Additional Disclosures

Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2019, J.P. Morgan Chase & Co. All rights reserved.

MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

Important Information

International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. Fixed income securities are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Dividends are not guaranteed and are subject to change.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.


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