Emerging Market Debt – An Overlooked Opportunity

Kristin Ceva, head of emerging markets debt strategies at Payden & Rygel, shares timely insights in a new Q&A that challenges outdated perceptions of risk and highlights where investors may find value in today’s complex macro landscape. 

How do you view the macroeconomic backdrop for EM debt right now — are the stars aligning for this asset class?

Global investors may have become overallocated to the US in recent years. The world’s exposure to US equities and bonds looks disproportionately high versus its share in global output or trade. As US policies turn inward and investors consider reducing their US concentration, EM debt presents significant opportunities.

EM debt remains one of the most underappreciated sectors in public markets, and we believe investors should maintain a structural allocation to this asset class. For investors who prefer to be invested in dollars or euros, EM sovereign-focused funds can provide access to government-issued bonds in about 80 different countries, while earning attractive running income of 7-8%. For those who like dollar bonds but are more comfortable with corporate credit, EM corporate-focused funds can diversify in over 50 countries and upwards of 800 corporate bond issuers, across all sectors. Investors might have interest in exposures outside of the US dollar; local market-focused EM debt funds can provide compelling carry across roughly 30 different countries and currencies.

What’s your outlook for the next 12–18 months? Where do you see the greatest opportunities — and the biggest risks?

The outlook for the next year is positive, overall. EM growth rates have been resilient. In a context where growth in the developed world may struggle to exceed 1.5-2%, EM countries, in aggregate, are expected to expand at a rate of 4% or more. Inflation rates in EM economies have normalized, and most EM central banks have room to lower policy rates. Countries’ balance-of-payments positions are sound; this means they are less reliant on foreign financing, making them resilient to shifts in capital flows.

While US tariffs caused a stir, the US quickly backed down from worst-case outcomes. The EM debt sector is by and large shielded from dramatic tariff effects. EM countries have been diversifying trade relations over many years, and most have low or manageable exposure to the US market. Tariff effects may have the most impact in places like China and Europe, neither of which are featured prominently in EM debt portfolios.

One of the top risk factors that can affect EM countries as a whole, is the strength of the US dollar. During times when capital flows shift heavily towards the US, it leaves EM countries with less funding and puts pressure on EM central banks to run tighter policy to manage the fallout. This risk factor has been diminished in the current context.

One opportunity for investors is the potential appreciation of EM currencies, particularly against the US dollar. History shows that the dollar can depreciate significantly over a multi-year cycle, even without jeopardizing its role as a global reserve currency. We are coming off a 12 year cycle of US dollar strength, where various metrics suggest high dollar valuations against much of the rest of the world. Also, with inflation contained and possible disinflationary forces brewing – including slower growth, lower energy prices and stronger currencies – duration in non-US bond markets is looking more interesting.

We believe that elevated all-in yields in EM debt compensate investors well for the choppier waters in the global economic landscape.

EM bonds often carry a perception of high risk. What do you say to this?

EM debt has existed for over 30 years and has matured as a sector. There is a greater array of countries and companies to invest in than ever before. Borrowers are more communicative and transparent, while information quality and data availability has improved. The investor base is seasoned and sophisticated. The trading environment is vibrant, allowing for efficient pricing of risk.

EM debt is not segmented by credit quality; we can invest in issuers with ‘AA’ rated quality all the way to the bottom of the rating spectrum. As active investors, we analyze fundamentals and valuations to seek out parts of the market that offer appropriate compensation for risk. We can stay away from areas that don’t pass muster. For example, at any given time there are about 20 countries where we hold no exposure.

From a broader perspective, emerging markets, which are already home to the bulk of the world’s population, are also producing a growing share of the world’s output. The developed world is ‘greying’ fairly quickly, whereas the developing world is not. While developed markets will remain a core component of portfolios, investors should be considering the growth and income opportunities of other, dynamic parts of the world.

Are there specific regions or countries you’re especially bullish on right now?

We see value in local bond markets, including Brazil, Mexico, Peru, Indonesia, Hungary, Czechia, Turkey, South Africa and Egypt. We are taking on the currency risk in some situations, while hedging away currency risk in others. Given the narrower than usual gap between US and EM policy rates, several markets offer attractive carry even if the currency risk is hedged.

In sovereign credit, we see opportunities in Argentina, Uzbekistan, Paraguay, Costa Rica, Guatemala, Sri Lanka, Mexico, Hungary, Ghana, Zambia, Morocco and Albania, among others.

In the EM corporate space there are a variety of interesting opportunities. A few we like are Brazilian consumer, industrial and transportation companies, financial and utility names in Mexico, utility and telecom companies in India, Peruvian financials, Guatemalan consumer and Chilean utilities.

How do you identify alpha in such a broad and diverse universe?

Payden & Rygel has always prioritized a thorough understanding of the economic and political dynamics of each country we invest in. We feel that focus, alongside prudent risk management that has always been a strength of our firm, has helped us maintain a competitive track record. The stability of our team, now with almost 30 years of experience investing in EM bond markets, helps us keep perspective through periods of uncertainty.

Are EM bonds becoming a more attractive alternative to U.S. corporate debt?

EM debt can play a complementary role to US corporate debt; we see the role of EM debt as adding diversification and incremental income. Over time, EM dollar-denominated bonds have generally offered additional compensation relative to similarly-rated US corporates. At the moment, that extra compensation is about fair versus history.

Our thought would be that investors are likely to have a healthy allocation to the US corporate market already and could benefit from an allocation to EM bonds. In this economic cycle, we think investors might also want to think about their non-dollar exposures and consider owning EM local currency bonds.

Have you made any significant shifts in your portfolio recently in response to geopolitics, elections, or central bank moves?

We have made three main portfolio shifts. First, we have pared back risk in certain high yield credit markets, particularly those with greater oil exposure. We still like the attractive income of high yield, and we are overweight this part of the market, particularly ‘BB’ rated issuers. But we are mindful of the impact of market volatility on more vulnerable credits. Second, we have increased holdings of local bonds, with the idea that duration can perform well outside of the US in a broadly disinflationary environment. Finally, we have taken increased currency exposures against the US dollar. Currencies are never a one-way street, and our positioning is carefully calibrated; we are far from a ‘maximum’ position. That said, the long-run overvaluation of the US dollar, in an environment where global investors may be re-thinking their elevated holdings of US assets, could erode the strength of the dollar looking ahead.

Kristin Johnson Ceva, PhD, CFA, is a Managing Director at Payden & Rygel. Kristin is a member of the firm’s Investment Policy Committee and is a Senior Portfolio Manager directing the firm’s emerging market debt strategies. She also is a frequent speaker at industry forums and in the media, focusing on topics related to international investing and emerging markets.

ABOUT PAYDEN & RYGEL

With $165 billion under management, Payden & Rygel is one of the largest privately-owned global investment advisers focused on the active management of fixed income and equity portfolios. Payden & Rygel provides a full range of investment strategies and solutions to investors around the globe, including Central Banks, Pension Funds, Insurance Companies, Private Banks, and Foundations. Independent and privately-owned, Payden is headquartered in Los Angeles and has offices in Boston, London, and Milan. Visit www.payden.com for more information about Payden’s investment offerings, including US mutual funds and Irish-domiciled funds (subject to investor eligibility).

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