Picture you are a medical student; your income is likely sparse and earning potential is probably the only argument to prove credit worthiness when seeking a loan. As a result, the amount that can be borrowed is often limited and borrowing rates are typically higher.
As you transition from med school to residence to practice, you acquire assets, pay your bills and build credit history, improving your credit worthiness. Eventually borrowing becomes easier and more affordable. This virtuous cycle is often what emerging market economies experience when turning to the market for financing.
Much like medical students, emerging market countries like Indonesia, Poland and Thailand have faster growth prospects, but they also have greater perceived default risk due to the potential for economic, political and social instability.
Another parallel, some medical students and emerging markets need financing to help them reach that earning and growth potential—which means they will need to pay a premium to encourage investors to take on the default risk of the loan—a compelling proposition for investors.
Debt vs. stocks
Typically, when investors think of emerging market investing, equities get most of the attention. The prospect of greater equity returns is spurred on by higher earnings potential and a premium for investing in a "riskier" asset class. While there are bumps in the road, emerging market stocks can provide attractive long-term results.
So why bother with emerging market debt? Long-term returns have also been impressive. In fact, over the last 20 years, the premium for investing in emerging market debt relative to developed market debt has been greater than the premium from investing in emerging market equities relative to developed market equities. It is important to note however that emerging market debt is more volatile relative to developed market debt whereas emerging market equities share a similar risk profile to developed market equities.
We should also consider the diversification benefits—50% of the MSCI Emerging Market Equity Index is dominated by just three countries in one region (Asia) - China, Taiwan, and South Korea. Compare that to the JP Morgan Global EMBI Core Index (U.S. dollar denominated emerging market debt index) and no one country accounts for more than 6%.
Local currency versus U.S. dollar denominated
Traditionally, emerging markets have issued debt in U.S. dollars to mitigate the risk from currency volatility and to make it more attractive to foreign investors. This is called “hard" currency debt since lending in U.S. dollars, mitigates some of the risk of the borrowing country devaluing its currency to pay its debt back.
But as emerging market economies mature and thrive, that virtuous cycle we described at the beginning of this article means they've become increasingly credit worthy. That's made local currency debt more compelling for investors. If you look at local currency emerging market debt indices, no country represents more than 10% and the top countries are Brazil, Mexico, Indonesia, Poland and South Africa—a composition that is quite different from the Asian heavy emerging market equity indices.
How MD is investing in emerging market debt
In the MD Strategic Yield Fund and the MDPIM Strategic Yield Pool, we invest in both U.S. dollar and local currency emerging market debt with a strategic allocation of approximately 15%. We prefer higher credit quality and greater stability (we currently hold a higher than strategic weight in U.S. dollar denominated assets) at this time as the global business cycle has slowed.
Diversification remains our focus, both regionally and across asset classes within the MD Strategic Yield Fund (and the MDPIM Strategic Yield Pool) and at the overall portfolio level. Emerging market debt will continue to play an increasingly important role in providing diversification and attractive yields.
Emerging markets are a lot like medical students in need of financing to help them proceed along the journey to an exciting and rewarding career. Similarly, emerging markets need to attract financing to help realize their earning potential as well.
For more information about emerging market debt, the MD Strategic Yield fund, or how you can implement this strategy into your portfolio, please contact your MD Advisor.