Last week, we discussed the appeal of emerging market (EM) equities. This week, let’s move up the capital structure and take a deeper dive into EM debt. Bonds are generally considered safer investments relative to equities. Bond holders receive predetermined interest payments during the life of the bond and principal payment on maturity of the bond. With U.S. and developed market interest rates near historic lows, investors who depended on bond incomes have had to expand their horizons in search of current yields. Bonds issued by EM countries and companies present an appealing alternative.

These bonds generally offer juicier yields relative to their developed market counterparts; however, investors should understand the underlying factors driving this market. EM debt can provide investors with the benefits of diversification and the potential for higher yield than traditional fixed income vehicles. In the near term, however, it could be in the crosshairs of some of the developments happening here in the U.S.

What Drives EM Debt Performance?

Global economic recovery favorable for risk assets. EMs are considered riskier investments than developed markets, and flows into EM assets generally mirror the risk sentiment of global investors. When there are rising risks on the horizon, like we had with the pandemic last year, investors’ first natural instinct is capital preservation, and so they flee from riskier investment destinations like EMs. On the other hand, when economies recover, capital starts flowing more freely. Consumers are willing to spend, companies are willing to undertake capital expenditure, and investors are willing to lend or invest in consumers and companies that are spending. Investors also gain confidence in deploying their capital beyond domestic borders to benefit from economic recovery elsewhere. This is what we are witnessing now as economies emerge from the shadows of the pandemic. The global manufacturing Purchasing Managers’ Index, which is a good proxy for the global economic cycle, has moved above its historical average, suggesting a nascent economic recovery. This is positive news for EM debt. If this economic trend continues, it could continue driving global capital flows into EMs.

Strong fundamental underpinnings. EM debt is considered riskier than developed market debt for several reasons. EM countries generally have more precarious fiscal and monetary conditions than developed market countries. It doesn’t take much to destabilize them. There have been several instances in history of EM sovereigns and companies defaulting on their borrowings, and they frequently need outside support to manage their affairs. This begs the question, with the pandemic still wreaking economic havoc in many parts of the world, is it worth risking our capital in some of the weaker regions of the world that are less equipped to handle it?

Let’s consider what happened in 2020. Almost all the countries had to borrow for pandemic spending last year. EMs were no different. The average debt-to-GDP ratio for EMs rose from 48 percent in 2019 to 60 percent in 2020. But with interest rates tanking across the world, even with the higher borrowing, debt servicing costs did not rise materially. When buying a home, a lower mortgage rate means we can afford to buy more home for the same monthly payment. Similarly, EMs were able to borrow more without causing a strain on their finances. This helped them handle the economic decline during the pandemic and will help shore up their finances for years to come. Some countries were able to take advantage of the emergency lending programs introduced by the IMF. A few outlier countries with the weakest credits did restructure their bonds or default on them. Overall, the worst could be behind us in terms of credit vulnerabilities in EMs, and the future could be much brighter.

Diversification appeal. One of the fundamental appeals of EM bonds is their low correlation to most other investments that are held in U.S. investors’ portfolios. A low correlation means that they may not get similarly affected by market forces as the other assets in the portfolio. Thus, incorporating EM bonds helps with the goal of building a diversified (“all-weather”) portfolio.

Rising U.S. interest rates reduce the allure of EM debt. One of the fundamental drivers of flows into EM debt is the higher yield generated by these investments. In a world starved for yield, investors turned to EM debt for the promise of generating a higher income. Of course, higher-yielding assets do not come without strings attached, as there is higher risk embedded in both sovereign and corporate EM debt securities. U.S. interest rates have risen since the lows of last year. The 10-year U.S. Treasury note yield was as low as 0.5 percent in summer 2020 and has risen more than three-fold since. As U.S. interest rates rise, there is less incentive for investors to underwrite the higher risk of EM borrowers.

Direction of the dollar matters. The dollar is considered a safe-haven asset and a place to hide when risks rise exponentially. This occurred in March of last year, causing the value of the dollar relative to other currencies to rise quickly and exponentially. Positive vaccine news and signs of economic recovery have led the dollar to decline since. But it has marginally appreciated again since the start of 2021, as the U.S. economic outlook has improved and interest rates have risen. This has a bearing on EM debt. For EM borrowers who borrow in U.S. dollars, a richer dollar means their currencies are worth less; hence, they must make their loan payments by expending more of their own currencies. For local currency EM borrowers, the direction of the dollar may not have a direct impact. For an investor in local currency EM debt, however, a stronger dollar means that the same local currency debt payment is translated back into fewer dollars.

Is the Higher Risk Worth It for Investors?

We know that EM debt is riskier and, hence, pays higher yield. But how much higher yield does it pay? This is measured by the spread or the excess yield of an EM bond over a Treasury bond of comparable maturity. When the markets got incapacitated in March 2020, EM yield spreads blew out. In other words, investors demanded much higher yield for betting on the EM borrowers’ compressed ability to pay. As countries and companies recovered from the lows of 2020, investors regained confidence in the EM borrowers’ ability to repay their debts. With this, their demand for higher spreads abated, such that EM debt is now trading at close to historic average spreads. In other words, they are valued close to historic averages. Bear in mind, we are in a much better position now than we were in March 2020. Vaccinations are ramping up globally, which means the end of the pandemic is in sight. Economies are recovering, and consumers and businesses are spending again. Earnings are rebounding. But at current valuations, EM bonds have less room for upside even as they are vulnerable to risks of potential derailment in recoveries.

Beware of Near-Term Risks

EM bonds will benefit from the post-pandemic global recovery currently underway. The EM debt universe has stronger fundamentals today despite the economic mayhem caused by the pandemic. Its differentiated growth drivers mean it offers diversification benefits to traditional portfolios. In a low-rate world, it offers the opportunity to generate higher yield to meet the income needs of investors. But in the near term, it remains a victim of volatile capital flows, rising U.S. rates, U.S. dollar consolidation or possible strengthening, and tight spreads or richer valuations. EM bonds are an asset class that warrant an active approach and a tolerance and capacity for higher volatility. It requires a greater appreciation for the macro drivers of risk and return for the asset class and a long time horizon.

The Purchasing Managers' Index is an index of the prevailing direction of economic trends in the manufacturing and service sectors. Emerging market investments may involve higher risks than investments from developed countries and involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation.

Editor’s Note: The  original version of this article appeared on the Independent Market Observer.