Capital Ideas^™ 
Investment insights from Capital Group

In today’s low-rate environment, investors looking for income need to use every tool in their toolbox. For many in the U.S., the first inclination is to turn to high-yield corporate bonds. Though these bonds can be an important part of an income-focused portfolio, we believe that investors should also consider an allocation to emerging markets (EM) debt.

The evolving breadth and depth of emerging markets provide active investors with significant relative value opportunities. The idiosyncratic nature of the asset class also makes it a natural complement to largely U.S.-centric high-yield corporate bonds. It can provide the twin benefits of income and diversification in an income-seeking bond portfolio.

As we look at the market today, EM debt should benefit from the ongoing post-pandemic global economic recovery. Additional support may come from stable to rising commodity prices, growing external surpluses, low developed-market interest rates and predictable monetary policies alongside an abundance of global liquidity. The predominant risk to this constructive scenario is if elevated levels of inflation persist for an extended period, forcing major central banks to remove monetary accommodation at a faster pace relative to market expectations.

That said, we still believe valuations and yields in many areas of EM debt are reasonably compelling and are likely to benefit from a supportive economic backdrop. As long as we continue to see even modest global economic growth rates, we believe that there is value to be found across all segments of EM debt, including U.S. dollar-denominated bonds (investment-grade, higher yielding sovereigns, EM corporate bonds) as well as local currency debt. Each of these segments has characteristics that can serve as important building blocks of a well-rounded portfolio.

We recognize that many institutional investors prefer to make deliberate and discrete allocations to the dollar-denominated and local currency bond segments of the EM debt universe. As such, we will separately discuss the merits and current relative value opportunities in both.

Current opportunities in hard currency bonds

Looking first at hard currency sovereign EM debt (which is predominately issued in U.S. dollars), as shown in the chart below, yields for the sub-investment-grade segment of these bonds are comparably higher than U.S. high-yield corporate issuers, providing investors with an additional and differentiated source of potential income generation.

Furthermore, the ratings composition of the two sectors is also similar, with more than 80% of both segments now rated either BB or B. The market for these bonds is significant, constituting 39% of the $1.3 trillion J.P. Morgan EMBI Global Index. Currently, some countries where we find value include Angola, Egypt and the Dominican Republic.

Emerging markets corporate bonds are one of the fastest growing sectors of the asset class, currently valued at $1.3 trillion. Valuations indicate these bonds may be particularly attractive across a variety of below-investment-grade (BB/Ba and below) issuers. Like their sovereign counterparts, these bonds offer favorable yield characteristics and opportunities for geographic diversification relative to U.S. high-yield corporates. Additionally, more than half of the issuers are rated BB/Ba, thus exhibiting a similar credit ratings profile to their U.S. counterparts.

Select local issuers offer attractive yield and diversification benefits

As the chart above also shows, local currency EM sovereign bond yields compare favorably to U.S. high-yield, while offering both low correlation and currency diversification benefits to an overall income-focused portfolio.

The overall local currency bond universe, as defined by the J.P. Morgan Government Bond Index - EM Global Diversified, is investment-grade rated with an average rating of BBB. Local currency EM bonds have also historically been less correlated to equity indexes like the S&P 500 than hard currency EM sovereign and U.S. high-yield corporate bonds. (Correlation is a statistical term describing the degree to which two numbers move in coordination with one another.)

We laid out our case for local currency emerging markets bonds earlier this year, and our view has not fundamentally changed.

While currency-related volatility is often a concern for some investors, we believe the overall benefits of U.S. dollar diversification and income outweigh those concerns.

There are a variety of factors that influence the valuation of the U.S. dollar, making it difficult to predict its exact cyclical inflection point. That said, valuations suggest that the U.S. dollar is currently overvalued relative to a broad basket of both developed and emerging markets currencies with a variety of potential catalysts to the downside, including:

 

• An ongoing synchronized rebound in global growth that is supportive of export economies
• Prolonged monetary policy accommodation from developed market central banks
• The Fed’s shift toward average inflation targeting that has allowed inflation to run above target
• A sharp rebound in commodity prices

Within local markets, some examples of higher quality issuers that we currently hold include China, Mexico, Peru and Malaysia.

The bottom line

In a world where income is hard to come by, investors may consider broadening their view beyond U.S.-centric high-yield corporate bonds to include a strategic allocation to emerging markets debt. Some investors may prefer discrete exposures to the U.S. dollar and/or local currency denominated segments of the market; and in the context of the current market environment, we believe there are attractive risk-adjusted opportunities in both of these areas.

That said, we also believe that a blended approach allows investors to maximize relative value potential across the asset class given the unique characteristics and distinct drivers of return inherent to each of these segments.