Why are EM bonds a value play?

By Peter Marber, Head of Emerging Markets and Portfolio Manager at Aperture Investors

What do you say to investors who consider emerging markets too risky?

Risk is a relative term of volatility and drawdown, and EM portfolios can be constructed to minimize these factors. That’s why investors need to understand the strategy in which they’re investing. Emerging markets include 100+ countries that are among the highest-rated credits in the world, as well as some of the lowest. They include agricultural countries with GDP per capita of less than 10% of the US, and they include other countries that have higher GDP per capita than the US. Savvy investors can build well-diversified EM portfolios that have similar levels of risk to those found in developed market portfolios. It all depends on the country and asset mix.?

Emerging market credit is a very misunderstood space

You describe EM bonds as a "misunderstood “value play.” Why?

Look at the data. EM and US default rates have both averaged around 3.5% per annum over the last 20 years, although they vary in any given year. Despite that fact, EM issuers with the same credit ratings as US issuers have paid spread premiums of 50 to 100% more on average. That’s the “value play.” For the last two decades, EM issuers have tended to overpay bondholders relative to statistical default risk. That’s why they are a great diversifier for bond investors - investors can own bonds from countries with different liquidity, interest rate and business cycles while earning higher returns without additional credit risk.

Now, you might ask, why these structural premiums still exist. Why haven’t they been arbitraged away? My answer: there are just so many surprises in emerging markets – investors want to get paid for that surprise risk.

All you have to do is look at Russia’s recent invasion of Ukraine. Before the attack, Russia had $640bn of hard currency reserves and the lowest debt-to-GDP ratio of the top 15 governments in the world. It was investment grade rated. Yet within three weeks of the offensive, Western sanctions rendered the country uninvestable, and its securities were kicked out of most bond and stock indices. Truly an amazing turn of events. I think this is why investors always want those extra premiums. They’re what Seth Klarman calls the “margin of safety” to invest in the unpredictable EM space.

How has the emerging markets investment landscape changed since you entered the industry in the late 1980s?

The world is remarkably different today. When I started my career, only a dozen countries had credit ratings and none were for an emerging market or a “lesser developed” country as they were called back then.

Many socialist EMs, such as China and former Soviet countries, had no stock or bond markets. And many EMs were in trouble - heavily indebted in hard currency, dominated by uncompetitive state-owned enterprises with no market-based capital or discipline. A generation later, these countries now account for more than 50% of the world economy and 25% of financial markets. They are too big to ignore. There are more debt, equity, and derivative opportunities than ever before in these countries, and investors now really need to consider not just “an” emerging market strategy, but “what” strategy fits their risk/reward objectives.?

EMs tend to overpay bondholders relative to statistical default risk. That’s why they are a great diversifier for bond investors

Is China too big and too different to be lumped with other emerging economies?

China reminds me of Japan in the 1980s. New Asian indices had to be created “ex-Japan” because its economy was much larger than that of any other country. If a country is one-third of an index and the next largest is less than 10%, the bigger country deserves a separate allocation. China is certainly in that category. That’s why we may start to see lots of emerging market “ex-China” indices.?

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