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Manager Insights

Emerging Opportunities in Emerging Markets Debt

Manager Insights Article Income Fixed Income
May 2020
Emerging Opportunities in Emerging Markets Debt

Reverberations from the current coronavirus pandemic are being felt in all aspects of the financial markets and all parts of the globe. Within emerging markets debt (EMD), spreads have hit historic highs, reaching levels not seen since the Global Financial Crisis. However, with each great economic crisis opportunities arise to take advantage of temporary dislocations in the market.

Historical Perspectives through a New Lens

The EMBI Global Diversified Index has a history of quick selloffs followed by equally quick recoveries. In the 11 worst selloffs in history, on average, the bulk of losses during each crisis were then recovered within three months and even saw new highs within 12 months. Additionally, each time the option-adjusted spread (OAS) gained above 400 basis points (bps), it represented an opportunity to make above-average returns in the following 1 to 3 years. This historical data could put current widening EMD spreads into a broader perspective of a possible fast bounce-back. Recently, the high yield portion of the aforementioned index moved to levels not seen since 2008 during the Global Financial Crisis. The investment grade part of the index widened as well, but it never quite reached the same levels as 2008.

 Source: JPMorgan data accessed via Bloomberg. Mellon calculations. As of May 18, 2020.

While many comparisons can be made between the impact of the Global Financial Crisis versus the COVID-19 pandemic on EMD, there are also a number of differences that we believe provide advantages to active investors in particular. The EMD universe has grown exponentially. Today, the universe constituents are much more diversified with over 60 countries compared to 28 in 2008. The level of investment grade debt is also greater; now over half the index consists of investment grade credit. We believe this larger and more diversified universe creates better opportunities for investors to take active and specific positions, delineating valuable opportunities and bringing them to bear on behalf of the client. Additionally, a more diversified universe is typically more stable.

Source:  JPMorgan data accessed via Bloomberg. Mellon calculations. As of May 18, 2020.

Further cementing the argument for EMD exposure, in their paper “Sovereign Bonds since Waterloo,” Josefin Meyer, Carmen Reinhart and Christoph Trebesch analyzed 200 years of this asset class’ history and came to the conclusion that, “as in equity markets, the returns on external sovereign bonds have been sufficiently high to compensate for the risks.” Additionally, they found that foreign currency bonds yielded an annual ex-post real return of 6.77%, even when including tumultuous periods of defaults, wars and revolutions. For comparison’s sake, this return is roughly 4% above US or UK government bonds and compares to stocks while outperforming corporate bonds.1 As seen in the chart above, there have been significant bounce backs after each of the top 11 drawdowns in the history of the benchmark. These historical data points create a compelling case for investment in EMD, especially during times of economic turmoil like we see today. Viewing EMD through a historical lens while also taking into account the broadening of the EMBI, now appears to show a prime opportunity to take advantage of active management.

1 J. Meyer, C. Reinhart, C. Trebesch (2019), Sovereign Bonds Since Waterloo, NBER Working Paper Series.

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