The Potential Benefits for European Investors of a Strategic Allocation to Emerging Market Debt

In brief

• We believe European investors should consider a strategic allocation to EMD. 
• EMD allows investors to gain access to higher-growth economies, and the asset class has matured in terms of market size, liquidity and credit quality. 
• The low correlation between local and hard currency EMD suggests that a blended approach is optimal. 
• EMD provides potential diversification benefits in broader portfolios, given the low correlation with other assets. 
  

After a tumultuous year for capital markets in 2022, investors will likely face more uncertainty in 2023. However, there are several bright spots — inflation is beginning to moderate, central banks are slowing the pace of tightening and fixed income valuations are now attractive across many sectors.

Against this backdrop, emerging market debt (EMD) may warrant a closer look for European investors as it offers attractive yields relative to other fixed income asset classes with lower volatility than equity assets.

While emerging market investing is familiar to European investors, it is often underrepresented across portfolios. Much like emerging market equities, EMD allows investors to gain access to higher-growth and higher-productivity economies compared to developed market economies. Additionally, EMD has matured significantly as an asset class over the past 30 years. In the early 1990s, there were few countries in the index, and crises from the mid-1990s to the early 2000s resulted in the asset class being perceived as a high-risk proposition. Today, many EMD issuers have robust debt profiles and better credit quality than in the past. Furthermore, the depth and breadth of liquidity has increased as the size of the overall market has grown to approximately €4.7 trillion,^₁ and EMD now comprises nearly 16% of the global bond universe.

Exhibit 3 shows the correlations between the different EMD assets, and we see a potential diversification benefit between hard and local currency with a correlation of roughly 0.7, varying slightly depending on whether the hard currency is hedged to euros or not.

Assessing EMD in a euro investor’s portfolio 

To analyze the potential benefits of adding EMD in a euro denominated portfolio, we estimated the potential returns that a euro-based investor might experience over the next 10-years. We started with current yields and then made adjustments for hedging costs, default rates and currency depreciation based on current market conditions. We then estimated volatility based on historical data and calculated expected Sharpe ratios, as shown in Exhibit 4.

Using these assumptions, we modeled varying combinations of local and hard currency EMD, as shown in Exhibit 5.

We see that the highest Sharpe ratios occur within a range of 40%/60% and 80%/20% hard currency/local currency EMD and the Sharpe ratio for the blended portfolios are slightly higher than either unblended portfolio. This synergy is a result of the low correlation between hard and local currency EMD that we saw in Exhibit 3. This leads us to conclude that a 50/50 blend of hard and local currency is potentially a good starting point to implement the asset class for euro investors. 

While the calculations in Exhibit 5 assume that the hard currency EMD is hedged to euros, it should be noted that we obtained similar results when using an unhedged variation of the hard currency EMD. We suggest that euro-based investors hedge the hard currency strategically but allow leeway to reduce the hedge tactically as market conditions warrant.

Integration with other asset classes

Another factor to consider is the correlation of EMD with other assets commonly held in euro denominated portfolios, as shown in Exhibit 6.

Those correlations, ranging from 0.42 to 0.79, indicate that EMD could potentially help diversify broader portfolio risk.

Conclusion

We believe European investors may want to  consider a strategic allocation to EMD. EMD allows investors to gain access to higher-growth economies, and the asset class has matured in terms of market size, liquidity and credit quality. The low correlation between local and hard currency EMD suggest that a blended approach may be the optimal one. EMD also provides potential diversification benefits in broader portfolios, given the low correlation with other assets.

Endnotes

^₁ Source: J.P. Morgan, market capitalization of JPMorgan EMBI Global Index, JPMorgan CEMBI Broad Diversified Index and JPMorgan GBI-EM Global Diversified Index, as of December 2022, converted to euros.

^₂ Estimated hard currency returns are based on index yields or the JPMorgan EMBI Global Diversified and JPMorgan GBI-EM Global Diversified Indices as of 12/30/2022 adjusted as shown below to reflect estimated cost of hedging hard currency index, long term historical average of default and recovery and projected differential in inflation between Eurozone and countries represented in the local currency index. Estimated default rate based on weighted average sovereign net annual foreign currency credit rating default for AA, A and BAA rated securities from 1975 to 2021. 

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