Emerging Markets Debt Remains Attractive
The emerging markets (“EM”) debt asset class is an approximately $2.5 trillion market – twice the size that it was in 2008, and twice the size of the U.S. high yield market today. The EM debt market includes fixed income securities issued by emerging market countries’ governments and government-related entities (sovereign debt) and by corporations located in those countries, denominated in both U.S. dollars and local currencies.
Over the last decade, the EM debt market has been the beneficiary of rising investor demand and attractive fundamentals. A number of emerging market countries across Asia, Eastern Europe, and Latin America have been rewarded with ratings upgrades in recent years. Current and forecasted GDP growth is noticeably greater for emerging markets compared to developed markets. At the same time, the debt/GDP ratio for emerging markets has been shrinking and is significantly lower than that of developed markets.
In 2012, EM sovereign dollar-denominated debt returned 17.44%, while EM corporate dollar-denominated debt returned 16.74%, ahead of all other bond market sectors including U.S. high yield. 2013 is off to a mixed beginning with sovereign dollar returns negative (-1.64% through 2/28/13) while local market returns have been strong at +1.10%, and corporate dollar-denominated returns have been modestly positive at +0.67%. Dollar-denominated markets, particularly investment grade bonds with less credit spread cushion, have been negatively impacted by the recent sell-off in U.S. Treasuries.
We view the corporate and local market EM debt sectors as the fastest growing segments in the space with many of the most attractive investment opportunities. We also believe that weighting these segments more heavily may help provide a buffer against any meaningful backup in U.S. Treasury yields.
Given that spreads are at ever-tighter levels and yields are lower overall, we believe in being defensive in credit selection, focusing on issuers with BBB and BB ratings quality. However, tighter valuations in corporate EM debt are supported by an anticipated low default environment, generally solid issuer credit fundamentals, and favorable global liquidity conditions. In assessing local EM currency and debt, we prefer markets that benefit from favorable trade flows, have positive growth and debt fundamentals, and offer some yield advantage relative to U.S. markets.
The EM debt universe is not without risk. Potential threats include the impact of the U.S. fiscal situation and debt ceiling, continued EU area reforms, and rising instability in the Middle East and North Africa. On balance, however, our outlook remains generally positive for EM debt due to favorable growth, fiscal, and debt indicators. This view is further supported by strong retail and institutional interest in the asset class, which has created a meaningful and steady inflow of cash into the market.
Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates, or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.