Introduction

As GMO celebrates its 30th anniversary managing emerging debt this year, we offer our comprehensive guide to emerging debt markets. Given the tumultuous recent events – a global pandemic, defaults, repricing of interest rates, relentless strength in the U.S. dollar – we'll focus on the Why as a starting point. Then we'll dive into the proliferating How, covering strategies and vehicles. For the When, we'll give a quick overview of our Quarterly Valuation Update publication. Finally, we'll relegate the What to the end for those looking for a more detailed introduction to the asset class, including terminology, market structure, associated benchmarks, and an overview of GMO's history managing EMD.

Why Consider Emerging Debt at All?

Recent years have dented the returns (and therefore some allocators' enthusiasm) for emerging debt markets along with other public credit markets. Exhibit 1 compares the three main EMD types – hard currency sovereigns and quasi-sovereigns (JPM EMBIG-D), hard currency corporates (JPM CEMBIB-D), and local currency sovereigns (JPM GBI-EMGD) – with U.S. corporate high yield (Bloomberg USHY). 1 While for many years EMBIG-D and USHY were neck and neck, lately the latter pulled decisively away as EMBIG-D's longer USD interest rate duration took a one-time relative hit in 2022, and a spate of pandemic defaults and sanctions-related hits also took their toll. Meanwhile, unprecedented U.S. pandemic stimulus, coupled with creative alternative financing sources in private credit markets for U.S. corporate high yield borrowers, has perhaps shifted the default cycle from public high yield to private markets. In EM corporates, CEMBIB-D chugged along at a lower total return level (yet with a higher Sharpe ratio) but was hit recently by defaults in the huge China property sector. And GBI-EMGD – after a roaring start 20 years ago – has bounced around below its 2012 high-water mark! So why make a distinct allocation to EMD at all? Why not simply select a broader mandate (perhaps multi-sector fixed income or multi-asset credit) and let the manager decide when and how to allocate?

The answer relates to the concepts of value, alpha, and diversification.

Value

To make a strategic allocation to any risky fixed income asset, you must expect that it will deliver excess returns over your USD duration hurdle (USD cash or USD duration of some tenor), that is, it must offer value. For risky credit markets like hard currency EMD or U.S. corporate high yield, this boils down to a view that the credit spread offered is higher than your estimate of future losses due to default. This has generally been the case for both: Exhibit 2 shows the excess return (total return minus matched maturity USD duration return) for EMBIG-D and USHY, showing that over time they indeed offer value to greater or lesser degrees.

Whether local currency debt allocations will deliver excess returns relative to cash in the relevant funding currency (a U.S. investor, say, funding a local currency debt investment out of USD cash, or an Australian investor funding the same out of AUD cash) 2 is a two-part valuation question: FX and local interest rates. By far the more important question relates to the FX valuation. Here our assessment compares the GBI-EMGD currencies' weighted-average “carry” (excess yield differential of the basket of short-term local currency interest rates in GBI-EMGD vs. USD cash) to the aggregate fundamentals of the currencies (valuations, balance of payments, etc.). Note that, unlike hard currency credit (where credit spreads are positive), currency carry need not be positive. For example, with U.S. dollar short-term cash rates high at present (3-month U.S. T-bills are ~5.3%), a number of GBI-EMGD countries have had lower cash rates (e.g., 3-month bills in Czech Republic are ~4%, or -1.3% carry relative to U.S. dollars). However, if the fundamental valuation of CZK is such that it can appreciate by more than 1.3% per year, it can still deliver positive total return to USD-based investors. Comparing aggregate GBI-EMGD carry relative to aggregate GBI-EMGD fundamental valuations, therefore, is critical when assessing a local debt allocation. Secondarily, although still importantly, is the question of whether EM local currency bonds can outperform their own carry, which is exactly analogous to a USD investor wondering whether to extend duration from cash to 10-year U.S. Treasuries. Here we compare the price (bond carry relative to cash, rolldown, term premium) in each local market to fundamentals that drive bond excess returns (fair value based on Taylor Rule neutral rate, inflation basket, and risk premium measures). 3

Exhibit 3 decomposes GBI-EMGD's historical returns into cumulative contribution from currency spot return, currency carry return, and local currency bond excess return (over currency carry return). You can see that currency spot return has not been helpful to local debt returns in recent years, with the high-water mark for the GBI-EMGD in USD terms back hit in 2012. The 2022 rise in global interest rates is also notable: most EM local bond yields repriced higher in tandem, denting excess bond return contributions.

Therefore, as an allocation matter, we observe that starting valuation makes a much larger difference for local currency debt than for credit, whether EMD or HY. We've been saying this since local debt arrived on allocators' radars in the mid-2000s, publishing Facts and Fantasies about Investing in Emerging Country Local Currency Debt in May 2007. 4 In the When section of this paper, you'll see that finally, after about a decade, we believe medium-term allocations to local currency debt are warranted on valuation grounds. We dived into this topic recently in Emerging Local Debt: A Once-in-a-Generation Opportunity. 5

So, to answer our question about dedicated EMD vs. multi-sector-type allocations: because the credit spread for risky assets like EM credit and HY generally overcompensate an investor for actual credit losses, an “always on” allocation, either via dedicated mandates or via multi-sector credit strategies, is warranted. With the spate of pandemic- and war-related defaults behind us, we expect hard currency EMD to return to its pre-pandemic pattern of excess returns. Local currency debt, on the other hand, is more of an opportunistic allocation when valuations are supportive, as they are now. Frontier local debt, discussed later, is a new, potentially diversifying area for allocation.

Alpha

Emerging debt has been a high alpha asset class, and we're proud that at year-end, GMO led eVestment's peer rankings (Exhibit 4). Given the inefficiencies we see, we believe this will continue to be a high alpha space for some time. Exhibit 4 shows eVestment data for dedicated hard, local, and corporate EMD universes, as well as major ETFs. It also shows U.S. corporate HY alpha. After-fee median manager alpha has been positive in EM hard and local currency (although not corporate or U.S. HY) debt over the 1-, 3-, 5-, and 10-year periods, the tumultuous recent years notwithstanding. Given such high long-term delivered alpha in hard and local EM debt, it's curious to us the choice of passive ETFs, which typically underperform the benchmarks in line with their relatively high fees. 6

Whether such dedicated EMD alpha flows up to multi-sector or core-plus-type mandates is an interesting question we'll address a bit later in the How section. For now, the main conclusion is that hard and local currency EMD is a place with demonstrated high alpha potential, which we believe itself can be a reason to allocate.

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