01 May 2024
While US interest rate reductions may have been delayed, we will likely see some movement before the end of 2024. This has created significant interest in the traditional bond market, considering government and company issues, which has filtered into emerging market bonds. While there are additional risks associated with emerging markets, these risks are potentially offset by increased returns.
If you're looking to diversify your portfolio, there are several emerging market debt instruments to consider. These include:-
As the term suggests, these are issued by emerging market countries to service debt and fund public services and investment. While the default level is probably lower than you expect, Lebanon, Belarus, Sri Lanka, and Venezuela are in actual default, while Ethiopia, Ghana, and Zambia have defaulted on their latest debt payments. The long-term default rate for emerging market sovereign bonds is around 4% to 5%.
These are debt instruments issued by companies in emerging markets. They are often used to fund expansion, although they can also facilitate the servicing of existing debt. While sovereign bonds are directly related to the prospects of the local economy, corporate bonds relate to the underlying company's prospects. A recent report by JP Morgan suggested that default rates will be around 4% for 2024, a significant reduction from the 8% level of 2023.
Corporate and sovereign bonds issued in a local currency, in this case, an emerging market, also incorporate a degree of currency risk. In reality, there is a currency risk with any bond, but by definition, those denominated in an emerging market currency usually carry a significantly enhanced risk. If the underlying economy is strong and the currency reflects this, this can lead to very attractive returns; if not, there may be a greater risk of default.
When researching the bond market, you will notice that many emerging market governments and companies issue their bonds in dollars. In many cases, this will widen the appeal for investors and reduce the currency risk, although there will still be an exchange from the local emerging market currency to the dollar when making interest and capital repayments.
Many companies and governments issue a range of structured debts for specific needs using an array of derivatives. The derivatives offer a degree of protection, and the debt may also incorporate collateralised debt obligations and asset backing. It is slightly more complex than your stereotypical corporate bond or sovereign bond, and due to the degree of protection provided, returns may be lower.
There are many issues to take into consideration when looking at emerging market debt instruments, which include:-
Benefits
· Higher yield compared to developed markets
· Diversification for your portfolio
· Exposure to countries with strong growth prospects
Risks
· Currency exchange risk
· Political and economic risk
· Bond/debt liquidity risk in less developed markets
Many analysts believe that the investment grade and high-yield bond markets are already factoring in future interest rate reductions; hence, some areas may have limited value. Consequently, interest has filtered down into emerging market debt instruments due to attractive headline returns. As an investor, it's essential to consider your risk profile and diversification strategy and ensure that you understand the enhanced risk/reward ratio.
Even though the level of actual default in emerging market debt instruments is significantly lower than many people expect, this does not take into account distressed entities. For example, many countries look to the IMF in times of financial difficulties, with debt relief likely to impact the payment of bond interest and capital. Emerging market debt ETFs are available, which provide access to a broad range of bonds, thereby reducing overdependence on a small number of standalone bonds.
It is an interesting concept with potentially enhanced returns but it's also essential to appreciate the enhanced risks Back to News
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