Emerging Market Debt: A Wider Range of Opportunities, and Challenges, in 2021

Reasons to consider emerging-market debt from Nicholas Hardingham.

    Nicholas Hardingham, CFA

    Nicholas Hardingham, CFA Senior Vice President Portfolio Manager Franklin Templeton Fixed Income

    “Emerging markets are projected to remain the largest and fastest-growing segment of the world economy in 2021. The COVID crisis has widened the range of risks and returns in emerging market bonds. Navigating this universe will require more careful, country-by-country analysis than in previous years.”

    Despite the COVID Crisis, Emerging Markets Should Continue to Grow Faster than Advanced Economies

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    Both advanced economies and emerging markets were hit hard in 2020. Some observers declared themselves outright bearish on the emerging world because, according to them, emerging market (EM) governments do not have the budgets to deal with COVID as well as advanced economies.

    Despite this concern, however, there are overwhelming reasons why we believe investors will continue to back emerging markets in 2021.

    According to the International Monetary Fund (IMF), the COVID crisis will deepen advanced economies’ budget deficits by 11% of GDP (gross domestic product) in 2020, but by just 6% in emerging markets.1 As 2021 starts, government debt is expected to rise to 125% of GDP in advanced economies, compared with 62% in emerging markets.2

    Forecasts indicate advanced economies’ GDP will, on average, grow by 3.9% in 2021, while emerging markets’ GDP will grow by 6.0% and China’s by 8.2%!3 This is important because China is a growth engine to which many other emerging markets sell their commodities.

    In addition, EM government bonds are attractive to us, compared to other bonds, because they yield around 4% more per year than government bonds in advanced economies.4 Many investors, therefore, continue to see emerging markets as an attractive segment of the world economy.

    COVID Will Widen the Divides Between Emerging Markets in 2021

    Overall, emerging markets started 2020 in good shape. After the COVID crisis, however, some countries will do better than others in 2021.

    Among emerging markets, a first group comprises countries such as Chile and Poland, which have significant buffers to support their economies amid the COVID crisis. These governments can finance widening deficits while keeping debt levels sustainable, and they can continue to issue bonds at low interest rates. One-third of Chile’s financing requirements of US$12 billion in 2020, for example, will be sourced from existing assets and reserve funds.5

    A second group includes South Africa and Brazil. Countries in this group started 2020 with high debt levels, spending large shares of their budgets on interest payments. These governments’ debt levels are restricting their spending, but they have deep domestic capital markets and little debt in foreign currency. South Africa’s 2020 government deficit, for example, may push its debt to more than 80% of GDP, but it can raise most of this additional debt domestically, in local currency.6

    A third group includes countries like Suriname, or Sri Lanka, which has foreign-currency reserves of US$5 billion but external debt of more than US$50 billion.7 Governments in this group started 2020 owing large repayments, often with weak economies. The COVID shock has compounded this economic stress, and their governments have been shut out from raising private capital. Some of these countries have been given temporary relief by other governments to which they owe money. But to avoid debt crises, they will need to increase their multilateral borrowings from sources like the World Bank and the IMF.

    In addition to EM governments, many companies in these countries issue attractive bonds, in our view. EM corporate issuers typically pay higher interest rates than corporate issuers in advanced economies but, on average, have better credit ratings. Many of them are government-backed, like state oil company Petrobras, or large and well-diversified corporations, like Chinese e-tailer Alibaba.

    In recent years, EM corporate bonds have had lower default rates than corporate bonds from advanced economies, and they have outperformed EM government bonds in 2020 year-to-date.8 We expect their resilience to the COVID crisis will boost the market for EM corporate bonds in 2021, as investors become more comfortable with this asset class.

    Local Knowledge Will Be Key to Navigating EM Bonds in 2021

    EM bonds will offer a wider range of risk/return combinations in 2021 than in previous years, in our view. Bonds with the highest credit ratings are often regarded as the least risky, but their yields are typically lower. More speculative EM bonds tend to offer greater returns, with a greater risk of default or restructuring. We believe that understanding this universe in depth will be key to putting together successful portfolios for our investors.

    All the while, we need to be mindful of so-called “tail risks” (i.e., infrequent events with large consequences). Which countries or companies might suffer most from another wave of COVID? What is the chance of conflict in, say, the Persian Gulf or the South China Sea? Will more countries use the G20’s Debt Service Suspension Initiative (DSSI), and could that affect private investors like ourselves?

    At the end of last year, we pointed out that policies in advanced economies, such as US trade sanctions, might be decisive for emerging markets. In 2021, emerging markets’ major challenges appear, once more, to be mainly domestic. Shying away from emerging markets altogether means ignoring around 58% of world GDP.9 Instead, we believe, investors would do well to learn to navigate this space.

    ENDNOTES

    1. Source: International Monetary Fund, World Economic Outlook, October 2020. There is no assurance that any forecast, estimate or projection will be realized.

    2. Ibid.

    3. Ibid.

    4. Source: JPMorgan, October 31, 2020.

    5. Source: Chile Ministry of Finance, September 2020.

    6. Source: South Africa National Treasury, October 2020.

    7. Source: Central Bank of Sri Lanka, November 2020.

    8. Source: JPMorgan, October 31, 2020. JPMorgan CEMBI indexes compared with JPMorgan EMBI indexes. Indexes are unmanaged and one cannot invest in an index. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance.

    9. Source: International Monetary Fund, World Economic Outlook, October 2020.

    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets.