Emerging market debt can be a viable investment alternative to the lower yield core government bonds. The governance and financial prudence in some emerging markets is improving meaning that there is potential for a reduced risk of repayment default, yet the yields remain high. Some investors therefore can see this as an opportunity to increase their returns whilst also diversifying their asset portfolio with fairly low risk assets-high yielding assets.

Why invest in emerging market debt?

There is potential for further economic growth in emerging markets has been strong and there is scope for this to continue as demand increases with an increasing middle-class population. Emerging markets also rely less on demand from developed markets and can withstand slowdowns in economic growth that occur in the core-developed markets.

Some governments in emerging markets are in a strong financial position than before reducing the risk of default in the debt repayments. Emerging markets also have increasing trade ties amongst themselves thereby boosting exports which are supported by increasing domestic demand.

Population growth in most emerging markets is still on the rise and there is also an increase in the middle class & economically active population. An increasing population and a growing disposable income among most families, means the long-term economic growth outlook is promising.

Debt levels in most emerging economies are much lower than in developed countries. The euro zone has debt problems which have forced some member countries to take drastic austerity measures in recent years which have in turn hindered economic growth. The US which is the world’s largest economy has ever increasing levels of debt compared to its GDP which could negatively impact its economy.

Yields for emerging market debt are still much higher than in developed markets. However, the improved fiscal policy, governance and reduced risk of default mean there is potential that the yields will get lower. It is therefore important to note any continued improvements in ratings on an emerging markets debt will drive the yield lower, but it is still greater than that of developed markets.

The growth in emerging economies also helps their currencies gain value against those of developed markets which may be debased as part of fiscal policy to boost exports or held back by Central Banks. This will provide additional returns for investors whose initial investment will have been in the lower value emerging market currency.

Emerging markets offer portfolio diversification to asset portfolios which may already include equities and debt from developed market as well as equities from emerging markets.

Risks Associated with Emerging Market Debt

Market Risk: the confidence level of the emerging market in which the assets (bonds) are traded will play a huge part in determine the value of the assets. If there is positive sentiment amongst investors for this asset class, the value may increase and vice versa.

Liquidity Risk: if a portfolio’s assets need to be redeemed for whatever reason there must be willing buyers in market to sell the bonds to as required. Emerging market debt assets carry the risk that there may not be enough liquidity or market participants to purchase the asset that a portfolio wants to sell when required to do so.

Exchange rate risk: changes in exchange rates may reduce or increase the returns an investor might expect to receive independent of the performance of such assets. If applicable, investment techniques used to attempt to reduce the risk of currency movements (hedging), may not be effective. Hedging also involves additional risks associated with derivatives.

Custodian risk: insolvency, breaches of duty of care or misconduct of a custodian or sub-custodian responsible for the safekeeping of the Portfolio’s assets can result in loss to the Portfolio.

Interest rate risk: when interest rates rise, bond prices fall, reflecting the ability of investors to obtain a more attractive rate of interest on their money elsewhere. Bond prices are therefore subject to movements in interest rates which may move for several reasons, which may be political as well as economic.

Credit risk: the failure of a counterparty or an issuer of a financial asset held within the Portfolio to meet its payment obligations will have a negative impact on the Portfolio.

Derivatives risk: certain derivatives may result in losses greater than the amount originally invested. Counterparty risk: a party that the Portfolio transacts with may fail to meet its obligations which could cause losses.

Emerging markets risk: emerging markets are likely to bear higher risk due to lower liquidity and possible lack of adequate financial, legal, social, political and economic structures protection and stability as well as uncertain tax positions.