Emerging market debt (EMD) is rapidly becoming a mainstream asset class. But what are the key characteristics of EMD bonds and what should investors bear in mind?
Yield and price
In common with other types of bond, the price of EMD is inversely related to yield, the rate of interest on the debt. Think yield up, price down. Yield down, price up.
For the bonds issued by the governments of emerging market countries, there is a strong, inverse relationship between the prices of the bonds issued by a given nation and the prevailing level of interest rates in the country.
As an example, Brazilian sovereign bonds performed well over the first couple of months of 2017 as the country´s central bank cut interest rates.
Interest rate changes
Often, just changing market expectations on interest rates are enough to push government bond prices in one direction or another.
For instance, if a country reports lower-than-expected inflation, investors tend to view this as positive for the bonds issued by the country´s government, typically pushing up prices of the bonds in the market.
This is because central banks generally react to lower inflation by keeping interest rates lower than would otherwise be the case.
When EM countries issue debt to investors they want to pay the lowest possible rate of interest on the debt. Those purchasing the debt from the issuing country do so on the agreement that they will receive a regular interest payment, or coupon, which is typically fixed for the life of the bond.
As an example, in 2017 Mexico issued bonds paying annual coupons equal to 4.15% of the issue price, with the bond maturing in ten years.
Investors can hold the bond until maturity in 2027 and receive this same fixed coupon throughout the life of the bond, provided that Mexico continues to honour its debt repayments.
At maturity, the same investors will also receive their original investment (an amount known as the “principal”) in the bond back in full from the Mexican government.
However, an investor could alternatively elect to sell the bonds in the market well before maturity, passing on their right to receive the coupons and the bond´s principal at maturity to other investors.
As the price of the bond fluctuates in the market, it could be possible to sell the bonds for a profit within a relatively short time scale.
For example, the value of the bonds could increase if interest rates in Mexico fall or if investor demand for Mexican bonds rises.
Over the long term, a positive scenario for an investor in an EM bond would be that the economy and underlying fundamentals of the given country steadily improve, such that the country becomes more and more akin to a developed market.
For instance, robust, positive economic growth, above the average of developed countries, accompanied by relatively low inflation, could enable the given EM authorities to keep interest rates down.
In combination with this, a positive external trade balance, with growing exports, can also help EM countries to build up foreign currency reserves over time.
Such outcomes can effectively lead to EM countries eventually catching-up with their developed counterparts.
The valuations of both EMD and the local currencies of EM countries are likely to rise against this backdrop.
In contrast, a highly difficult environment for EM bonds would be “stagflation”, a situation where economic growth declines at the same time as inflation rises.
In this case, interest rates could need to increase significantly to combat inflation while the deteriorating economic situation could also see the country downgraded by credit ratings agencies and viewed as more likely to default on its debt repayments.
In such an adverse scenario, both the valuations of EMD and the local currencies of EM countries are liable to fall.
Risk versus return
For higher risk, investors naturally expect higher potential returns. The various segments of global bond markets vary in their risk/return profiles, with the bonds issued by the major developed countries viewed as the least risky, and hence with theoretically low potential returns.
Meanwhile, some of the bonds issued by large, global corporations are viewed as low risk, carrying an “investment grade” rating from the ratings agencies, a designation of high quality.
They are, however, also seen as being riskier than the major developed, government bond markets.