Perception vs. Reality: A look at the data
To begin, let’s take a look at the historical volatility of EM Corporate debt compared to the US Corporate index. While EM Corporate debt has experienced some periods of volatility, the overall trend shows that it has been less volatile than the US Corporate index over the past few years. In fact, the volatility of the J.P. Morgan Corporate EMBI Broad Diversified Composite Index (EM Corporates) over the past 10 and 20-years as of end April 2023 was at 4.9%, and 5.4%, respectively. While that of the Bloomberg Barclays US Corporate Index (US Corporates) was at 6.7% and 6.1% (see Figure 1). In terms of performance, EM Corporates outperformed US Corporates with an annualized return of 5.5% over a 20-year period as of end April 2023, surpassing the 4.1% annualized return of US Corporates. (Source: Bloomberg)
Next, let’s look at the risk-adjusted returns of the two indices. The Sharpe ratio, which measures the return per unit of risk, shows that EM Corporate debt compares favourably to the US Corporate index. Over the same 10 and 20-year period, the Sharpe ratio of the EM Corporates was at 0.41 and 0.78, respectively, while that of the US Corporate Index was 0.19 over 10 and 0.46 over 20-years, lagging the EM Corporates. This means that investors in EM Corporate debt were compensated with higher returns for the risk they took on. In Figure 1 we can see that return and volatility compares well to the US Corporate indices. (Source: Bloomberg)
What are the factors that drive the performance of EM Corporate debt?
It’s important to understand the factors that contribute to the performance of EM Corporate debt. One key factor is the economic growth of the Emerging Markets themselves. According the IMF1, Emerging markets have grown on average by 4.1% from 2013-2022 which compares to 1.8% for Advanced Economies. As these economies continue to grow and develop, their companies are better positioned to meet their debt obligations. Additionally, the credit quality of EM Corporate debt has improved over the years. A study from J.P. Morgan shows that Global Emerging Market indebtedness has improved with net leverage decreasing from 2.1x in 2016 to 1.1x as of end-2022. Another key aspect has been the lower duration of EM Corporates relative to US Corporates. As a reminder, the lower the duration, the smaller the sensitivity to interest rates. A lower duration therefore contributed to less volatility and in turn better risk-adjusted returns. EM Corporates historically had a lower duration than the US Corporates. As of end-April-2023 it stands at 4.3 years which compares to 7.2 years for the US Corporate Index, according to Bloomberg. Further, we believe that the superior risk adjusted return comes from a universe with higher dispersion. The idiosyncratic nature of return in EM leads to more diversification at the universe level and lower volatility for the same level of risk premium.
Investors shouldn’t overlook the potential of Emerging Markets
In conclusion, while EM Corporate debt may be perceived as risky, the data shows that it has historically been less volatile than the US Corporate index and has provided higher risk-adjusted returns. As with any investment, there are risks involved, but the improved credit fundamentals and economic growth potential of the Emerging Markets should not be ignored. Investors looking for diversification and higher potential returns may find EM Corporate debt to be an attractive addition to their portfolio. Active management is well suited for emerging market debt, as dispersions across geographies can be used to dynamically adjust the portfolio in response to changing market conditions. With local expertise and active monitoring of a company’s creditworthiness, risk can be managed, and opportunities seized more effectively.
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