Capital Ideas^TM

Emerging market debt (EMD) has already broadened and deepened significantly in the last few decades and as the asset class has developed, it has become more appealing to a broader investor base. Issuance has increased, thereby improving liquidity. Yield curves have become more developed, allowing active investors to add value via positioning across different maturities.

As these factors have improved, the ownership mix has diversified, with a greater balance between foreign and domestic owners. This trend looks set to continue over the next decade. As this happens, it will be more important than ever to access the market proactively.

While EMD has had a difficult start to the year, with rising inflation, monetary policy tightening by major central banks, Russia’s invasion of Ukraine and a slowdown in the Chinese economy, an active, research-based approach to investing can help identify attractive opportunities in emerging markets (EM), while mitigating risks.

Broadest possible universe

One benefit of an active approach is access to a wide source of potential returns, given the ability to take exposure from outside the universe of an index, and use multiple levers to capture different drivers of return and manage risk. Certain indices restrict the opportunity set available due to construction methodologies and constraints. This can be to the detriment of passive investors, as their exposure is (perhaps unintentionally) restricted to only a limited sub-set of the EMD universe, which has been pre-selected by the index providers. For example, many frontier markets (see page 6 for definition), as well as India, offer potentially attractive investment opportunities but have limited representation in the major EMD indices. As a result, foreign ownership of bonds has generally been low in these countries. Indian local currency government bonds have one of the lowest foreign ownership levels among emerging markets, at 1.9%¹, driven by their exclusion from the JPMorgan GBI-EM Global Diversified Index and the Reserve Bank of India’s cap on foreign ownership of bonds. The impact of such high domestic ownership levels tends to be reduced volatility as the market is less prone to shifts in international capital flows.

The chart below illustrates the growth of local currency EMD as an asset class, and the size of the JPMorgan local currency benchmarks in the context of the total size of the investment universe. In 2021, the combined market for sovereign and corporate local currency EMD stood at US$33 trillion (see chart below). In comparison, the market value of the JPMorgan GBI-EM Broad Index was US$4.0 trillion, while the JPMorgan GBI-EM Global Diversified Index represented only US$1.4 trillion.

As we have shown, the investable universe is often broader than that which the reference index implies. Access to a broader range of markets and instruments could potentially offer increased and more varied sources of alpha and can help to provide greater diversification.

1. Data as at October 2021. Figure is based on nominal local currency central government bonds. Sources: CEIC, Bloomberg, Morgan Stanley Research

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.