Emerging markets debt presents a strong investment case but is frequently overlooked and under-allocated as a fixed income asset. Given the favourable macroeconomic outlook and the diversification benefits it offers, emerging markets debt has now become a core allocation in many investors’ portfolios.

Making the case for EM debt

EM countries now account for over half of global gross domestic product. Over the last two decades, emerging markets debt has evolved significantly, given the remarkable growth in the breadth and depth of countries and the number of issuers. Issuance has increased, thereby improving liquidity, and yield curves have become more developed, allowing active investors to add value via positioning across different maturities.

As emerging markets matured, many countries began issuing bonds denominated in their respective local currencies rather than dollars. This has created a valuable sub-asset class worth almost $4tn.

For investors seeking a high level of current income and dollar diversification, EM local currency bonds can offer an attractive risk-reward trade-off. Countries that issue local currency debt tend to have independent central banks, developed yield curves and investment-grade credit ratings. Furthermore, high nominal yields and potential rate cuts from the US Federal Reserve can offer attractive entry points, especially for active managers who are adept at steering through the intricacies of the global landscape and the ongoing geopolitical shifts, as well as differentiate between the winners and the losers. But there are four key reasons to consider an allocation to EM local currency debt.

Diversification

Local yield curves of emerging market sovereigns tend to be quite varied since countries are often at different stages of monetary and fiscal cycles at any given time. This allows investors to evaluate relative value along the yield curve in individual markets as well as value across various markets.

Local bond markets provide greater variety of debt instruments

While hard currency bond markets offer investment opportunities in a broader range of credits in both sovereign and corporate debt, the variety of fixed income instruments and alternative hedging tools available to investors is greater in local currency markets. Alongside nominal bonds, investors can choose from inflation-linked bonds and derivatives, currency-linked debt, GDP-linked warrants and money market instruments – all of which can be used to diversify a portfolio and mitigate risk.

Local bond markets offer growth potential and greater depth

Liquidity – the ability to buy and sell assets without causing unfavourable shifts in their price – is where local bond markets possess a significant and growing advantage over their hard currency counterparts. With a market capitalisation of $3.86tn, the local currency bond market more than triples the hard currency market capitalisation of $1.2tn. This large and widening gap is of little surprise as governments are steadily developing local capital markets and replacing external debt with local currency debt to reduce foreign exchange risk and exposure to sudden shifts in foreign investor sentiment.

Potential for higher returns

Emerging market local currency bonds have the potential for higher returns relative to hard currency bonds. They also offer exposure to the economic growth and interest rate differentials of emerging markets, as well as the possibility of currency appreciation. At times, emerging markets local currency debt has provided a higher yield than its dollar-denominated counterpart but both have provided a meaningful pick-up in yield over US core bonds.

Emerging market local currency bonds offer investors a compelling combination of higher returns, diversification and inflation protection, which can enhance the performance and resilience of a fixed income portfolio. However, investing in local currency bonds also entails higher risks, such as currency volatility, political uncertainty or sovereign default. In turn, extensive fundamental research and active management is needed.

To view the article from Capital Group in full: Capturing opportunities in emerging markets with local currency bonds.