Judging by my conversations with clients around the world in the first quarter of 2024, many investors have realized that they are underallocated to emerging markets in their global fixed income portfolio. This is, in part, a response to the eye-catching returns of emerging market debt in 2023, when it easily outperformed both global developed market bonds and U.S. investment-grade debt.1
While some investors may be wary of exposure to faltering growth in China, the fundamental strength of emerging market bond sectors—external “hard currency” sovereign debt denominated in U.S. dollars or euros, corporate bonds, and sovereign bonds denominated in local currencies—and their attractive portfolio diversification characteristics are enough to make the case for a structural allocation to emerging markets.
Here are five factors that I think make a strong case for emerging markets in a global fixed income portfolio:
1. Improved credit quality, deeper capital markets
As various developing countries exited crisis periods in the 1990s and adopted needed reforms to make long-term growth and debt more sustainable, emerging market bonds have seen significant improvements in credit quality. In the mid‑1990s, there were no investment‑grade external sovereign issuers. Today, more than half of the emerging market opportunity set has investment-grade credit ratings.
Paralleling this improvement in credit quality, capital markets have deepened for emerging markets. The countries now primarily fund themselves in local currencies versus hard currencies, and emerging market corporate debt has seen steady growth over the last 10 years to become a larger opportunity set than emerging market external sovereigns. We expect the corporate market to continue to rise in prominence over the next 10 years and maintain its status as a less volatile way to access the strong economic growth of emerging markets.
2. Recent debt distress is catalyzing reforms
Those long-term improvements don’t hide the fact that some emerging market countries entail more risk than their developed market peers. This is particularly evident on the external sovereign side, which is only recently recovering from one of its most acute periods of debt distress since the 1990s. Today, nearly 50% of the credit spread in emerging market sovereign bonds2 originates from a handful of distressed markets. We’ve seen several CCC rated issuers default and restructure since the COVID crisis crippled many parts of the global economy and the Federal Reserve embarked on its most aggressive hiking cycle since the 1970s.
The upside is that the market should come out stronger