The Outlook for Emerging Market Bonds
Emerging market sovereign bonds that are issued in local currencies are supported by high real yields and improving credit quality. In addition, their risk-to-reward profile is enhanced by declining currency volatility and a positive long-term outlook for currency appreciation. This article explains why local currency emerging market bonds are attractive relative to historical valuation levels as well as current developed market opportunities.
If you are reading this article, you probably work in the financial services industry, and you have grown accustomed to friends, casual acquaintances, and even near-strangers expecting you to comment, with Cramer-esque authority, on penny-stock fliers, explain the latest day-to-day gyrations of the stock market, or reveal the secret code to the price path of gold futures. And, if you are like me, you might sidestep these questions and encourage your new friend to become a long-term investor in a diverse mix of index-based strategies.
Sometimes, however, you might receive a more interesting and open-ended investment question. My eyes always light up when I’m simply asked, “Where is your favorite place to invest today?” The answer, of course, depends heavily on current valuations and market conditions, but we always approach the question with an effort to understand the drivers of long-term risks and expected returns across many different asset classes.
So, you ask, where is my favorite place to invest? Right now, bonds issued by emerging market governments in their local currencies appear to offer far and away the most compelling investment opportunity. These bonds have four underpinnings for their exceptional risk-to-reward profile:
• High real yields
• Positive expected currency appreciation
• Declining currency volatility
• Strengthening credit quality
High Real Yields
First, note that emerging market sovereign bonds not only provide an attractive current yield relative to other market opportunities, but they are also relatively cheap compared to their historical average. The short- and medium-term “risk-free” government bond rates for the G-5 countries all currently reside in negative territory (see Figure 1). In developed markets, the right to a certain return of capital is actually costing anywhere from –1.5% to –0.5% per year in real purchasing power.1 On the other hand, real yields in many of the larger emerging market economies reside solidly in positive territory—returning anywhere from about a 1% premium over inflation in Mexico and Russia to more than 6% in the case of Brazil.
Emerging market bonds are also cheap compared to their historical values. In this age of ultra-low interest rates and sky-high equity valuations, cheapness is nearly a forgotten concept.Figure 2 charts the historical spread for the J.P. Morgan GBI-EM Global Index. At just under 7%, the difference between the index yield and the short-term U.S. Treasury rate lies well above its long-term average of 5.2%. But, most strikingly, this spread has rebounded (due to the well-documented “taper tantrum” of 2013) to levels just a touch below its all-time high during the 2008 global financial crisis! In hindsight, we can reflect on the many good values the market offered us at the end of 2008. Certainly risk was elevated, but so, too, were the proffered fruits for taking on that risk. How many asset classes are currently trading at comparable valuations? Knowing what we know now, wouldn’t we all love to have a second chance to buy risky assets at 2008 valuations? Most are now vastly more expensive, trading at spreads or valuations considerably richer than historical averages. On a pure yield and valuation basis, emerging market sovereign bonds stand head and shoulders above the competition.
Skeptical readers might object that this must be a sign of stressed markets, a value trap ready to snap shut. Aren’t the “fragile five” economies facing an impending rout of their currencies? This question brings us to the second and third factors supporting emerging market bonds. The volatility of local currencies is undeniably substantial; the currency risk swamps the volatility of the underlying bonds. Nonetheless, the currency exposures may provide an incremental boost to long-run expected return. Because of the differences in productivity growth, in the long run we expect emerging market currencies to appreciate relative to the U.S. dollar and other major developed world currencies.
The expected real return for investing in foreign bonds is the real yield on the bonds, less defaults, plus any movements in the real exchange rate.2 So what drives movements in the real exchange rate? One of the primary long-term factors is differing levels of productivity increase between two economies. Productivity matters because, even in open economies, not all goods are tradable. This drives higher inflation and thus appreciation in the real exchange rate in the economy with faster-growing productivity.3
Think of sports cars and hospital visits. Because cars are freely shipped across borders, their prices should be equalized. For example, suppose the nominal exchange rate of interest is 13 Mexican pesos to 1 U.S. dollar. Disregarding transportation costs and tariffs, a sports car selling for $100,000 in the United States should sell for about 1.3 million pesos in Mexico. There are very few “bargains” to be found by shopping abroad for tradable goods.
Hospital services, however, are a different story because they are non-tradable goods. As we age, we expect to spend less of our consumption budget on sports cars and much more on health care. Yet a Mexican hospital is not a viable substitute for my health care needs, if for no other reason than proximity. It’s easy to drive across the border and save a few thousand dollars on a car, but not on an emergency appendectomy! This opens up the possibility for non-tradable goods of all sorts to have dramatically different real prices. An emergency medical procedure may cost half a sports car in California but only a tenth of the same sports car in Mexico. I, for one, am not willing to arbitrage away that price discrepancy.
This relationship between productivity and the real exchange rate is known as the Balassa–Samuelson effect.4 Emerging markets’ higher rates of productivity growth drive higher wage growth and, therefore, higher price inflation in non-tradable goods. This propels an increase in the emerging market consumption basket relative to the developed market consumption basket, resulting in a rising real exchange rate. In fact, the long-run expected increase in the real exchange rate between two countries can be approximated by the difference in productivity growth rates (estimated by real per capita GDP growth rates). Depending on which countries you include in the analysis, the expected real exchange rate appreciation in a basket of emerging market currencies should be about 50 bps annually. For perspective, the expected currency appreciation alone is slightly higher than the expected real yield on a 10-year U.S. Treasury bond. Of course, these expected currency gains are small compared to the real yield on emerging market bonds. But it is comforting to know that the local currency exposure should add a long-term incremental return, rather than eat away at the attractive real yield through depreciation.
The next question for most investors is: What about the increased volatility associated with local currency exposure, particularly in the case of fragile emerging market currencies? This has certainly been true historically; for instance, the volatility of emerging market currency returns soared during the East Asian financial crisis of 1997 and the devaluation of the ruble in 1998. But would it surprise you to learn that the volatility of the Mexican peso to U.S. dollar exchange rate over the last five years has equaled that of the Norwegian krone to U.S. dollar (both at 12.3%)? Or that the most volatile of the fragile five, the South African rand, has delivered but a tad higher risk than the Australian dollar (15.2% to 14.9%)? In fact, as shown in Figure 3, the trailing five-year average volatility for emerging market and developed market currencies5 has converged substantially over recent years. Taking on any foreign currency exposure certainly adds volatility. But, at least for the past five years, a basket of emerging market currencies has contributed no more volatility to an international portfolio than a basket of developed currencies. And as emerging markets continue to do just that—emerge—the convergence of currency risks may be expected to continue.
The fourth factor is the strengthening credit quality of emerging market bonds. Indeed, it is not only currency risks that have been catching up with developed markets, but also the underlying economic risks to bond cash flow payments. Fifteen years ago trading in local currency emerging market bonds was negligible. Nobody wanted to lend to these countries unless the loan was denominated in an external currency, usually U.S. dollars. Since that time the market for local currency emerging markets debt has soared past $1 trillion, while external currency debt has grown from about $200 million to $500 million.6 Moreover, 15 years ago only a handful of countries were in a position to issue local currency debt, and their average credit rating was BBB+. Now many more countries participate in the local currency debt market, and the average credit rating is closer to A– (Table 1).
Interestingly, despite the tremendous growth in debt issuance, emerging market economies have not become overburdened. In fact, their economies have grown more quickly than they have issued debt, leading to a substantial drop in their debt-to-GDP ratios.7 Although their budget deficits remain higher than that of the average developed country, they are now well below their rate of GDP growth (something many developed market countries can’t claim). And lower deficits do allow for greater savings after all: total foreign reserves as a percent of external debt has more than tripled, with the average country holding close to one unit of foreign reserves for every unit of externally issued debt.8 And a major concern, sticky current account deficits, continues to pose problems for some countries, but the average deficit has shrunk. Additionally a new emphasis on stronger central banking in many emerging market countries (exemplified perhaps by India’s Reserve Bank governor, Raghuram Rajan) should help these trends continue and lend additional support to the development of these economies. The weight of evidence shows that the fiscal stability of emerging market countries dramatically improved over the last 15 years. According to some key metrics, they actually appear stronger than many developed market countries—they have lower debt burdens, lower deficits, and higher reserves. In a blind test, to which government would you choose to lend your money?
One of the most compelling investment opportunities at this time appears to be local currency emerging market debt. So, the next time you find yourself cornered at a cocktail party, just remember these four things: Emerging market local currency bonds appear to offer attractive real yields and improving credit quality. In addition, emerging market currencies may appreciate over the long term, and their volatility appears to be declining. While you may not be treated like a celebrity, you can take comfort in knowing that you are providing thoughtful advice.
1. Emerging market sovereign bonds are favorably priced relative to historical levels and other asset classes.
2. Because emerging market countries have high rates of productivity growth, their currencies are likely to strengthen.
3. The average volatility of emerging market and developed market currencies has converged substantially over recent years.
4. The credit quality of emerging market bonds has improved due to declining debt-to-GDP ratios.
Balassa, Bela. 1964. “The Purchasing Power Parity Doctrine: A Reappraisal.” Journal of Political Economy, vol. 72, no. 6 (December):584–596.
Catao, Luis A.V. 2007. “Why Real Exchange Rates?” Finance and Development, vol. 44, no. 3 (September):https://www.imf.org/external/pubs/ft/fandd/2007/09/basics.htm
Samuelson, Paul. 1964. “Theoretical Notes on Trade Problems.” Review of Economics and Statistics, vol. 46, no. 2 (May):145–154.
8 This average is certainly skewed by China’s large foreign reserve holdings at 471% of external debt, but China is not alone. Five of the 17 countries in our data set have a ratio above 100%.