CONTRIBUTORS
Mark Hughes, CFA
Despite the strong returns for emerging market (EM) fixed-income during 2023 (Exhibit 1), one thing has eluded industry practitioners in recent quarters—a compelling relative value argument for higher quality EM bonds. As we’ll discuss here, we believe that there are reasons to dust off EM investment-grade (IG) bonds as a core allocation, given that they appear poised to generate strong carry as well as potential upside from lower interest rates.
Exhibit 1: 2023 Fixed-Income Returns
Source: Bloomberg, JPMorgan. As of December 31, 2023. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
In search of relative value
Historically, IG-rated EM debt has been a strategic allocation for global bond funds, institutional accounts and insurance portfolios, as it typically offers both diversification and additional spread. Despite headwinds to EM fundamentals from the pandemic and central-bank-induced tightening of financial conditions, in recent years we saw an unusual compression of EM IG spreads relative to US credit (Exhibit 2), making the case for EM more challenging. Why did this countercyclical spread compression occur? We attribute it to technicals; during 2022 and the first half of 2023, we saw strong levels of US IG primary issuance that forced spread concessions, which contrasted with negative net issuance of EM IG debt.
Exhibit 2: EM Investment-Grade vs. US Investment-Grade Relative Value
Source: Bloomberg. As of January 31, 2024. OAS = Option-adjusted spread. Bloomberg EM IG is represented by the Bloomberg Emerging Markets Investment Grade Index. US Credit is represented by the Bloomberg US Credit Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
The good news for EM professionals and value-seeking investors is that despite strong performance from EM assets over the past 12 months, valuations for EM IG bonds have steadily improved relative to US credit since mid-2023. This trend has accelerated in recent months as a renewed EM primary calendar has come with spread concessions, keeping EM spreads from compressing as much as their US peers. This contrasts with US high-grade issuance printed on top of secondary spreads, in response to unrelenting inflows to that asset class. While those of us in EM would appreciate seeing similar inflows, the counter is that our more balanced technicals have led to the better valuations we’re seeing today—a 30-basis-point spread advantage that represents approximately a one-third premium versus US IG index spreads (Exhibit 2).
Tapping the primary market
While we continue to believe that most EM asset classes are set up for strong 2024 performance on the back of strong starting yields and the potential for lower rates, we also believe the valuation opportunity described earlier can help those investors with a higher quality orientation, and who may have been priced out of the EM market in recent years. Western Asset is taking advantage of the cheapening of EM IG spreads by participating in 2024’s robust supply calendar, which was kicked off as usual by Mexico sovereign issuing $7.5 billion of new 5-, 10- and 30-year bonds on January 2.1 As the first quarter has progressed, we have been encouraged by the breadth of issuers coming to the market, which, after a slow couple of years for issuance, adds to our investment universe and increases diversification as well as the potential for excess returns. Overall, given the recent strength, but historical tightness, of US IG spreads, we are seeing more clients interested in participating in the current opportunity in EM IG.
Monitoring fallen-angel risk
While all credit professionals are familiar with the risk of a fallen angel, investing in EM IG comes with additional sovereign-level considerations such as politics and fiscal policy that can impact an issuer’s ratings trajectory. Historical ratings migration trends for EM issuers are comparable to that of the US, but we would be remiss not to acknowledge previous sovereign fallen angels such as Brazil that impacted developed market (DM) bond investors. As a result, Western Asset’s EM investment process places a premium on sovereign-level fundamental analysis in an effort to ensure that the value we’re currently seeing in EM IG sovereign and corporate bonds isn’t eroded by ratings downgrades.
Endnotes
- Source: Andrade, V., Vizcaino, M. and O’Boyle, M. “Mexico Taps Global Markets With Record $7.5 Billion Bond Sale.” Bloomberg. January 2, 2024.
Definitions:
The Bloomberg Emerging Market Investment Grade Index is the investment grade component of the Bloomberg Emerging Market Index, a rules-based, market-value-weighted index engineered to measure USD fixed-rate sovereign and corporate securities issued from emerging markets.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes non-US agencies, sovereigns, supranationals and local authorities.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
"Fallen angels" refers to corporate bonds whose credit ratings have declined from investment-grade to high-yield.
The J.P. Morgan Corporate Emerging Markets Bond (CEMBI) Broad Diversified Index, which is a modified market capitalization-weighted index designed to measure the performance of the US dollar-denominated emerging market corporate bond market.
The J.P. Morgan EMBI Global Diversified Index (EMBIGD) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
The J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) tracks local currency bonds issued by emerging markets. Weightings among countries are more evenly distributed within the index than in the global diversified index.
The J.P. Morgan Next Generation Emerging Markets (NEXGEM) Index comprises countries that issue hard currency and local currency government and corporate bonds, small and less liquid local currency government bonds and local currency corporate bonds issued by non-NEXGEM countries in emerging markets.
An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.