As we approach the end of 2020, it is a natural time of reflection on a year that can only be described as a rollercoaster, with the Covid-19 pandemic ravaging markets, extraordinary stimulus packages around the world, and a dramatic US presidential election. Emerging market asset classes have felt these bumps acutely – weakening as the global pandemic took hold back in March and then rallying strongly in the subsequent months. 
With a still-uncertain economic environment, lingering risks on the horizon, and valuations that have snapped back from stressed levels, investors are now rightly asking if opportunities in emerging markets debt still exist. The answer, we believe, is yes—but selectivity is critical.
For investors looking to pick up incremental yield opportunities versus developed markets and gain exposure to the diversification on offer in emerging markets – but who are more risk-averse, particularly against the current backdrop – emerging market corporate debt, and more specifically, short-duration debt, could be part of the solution. But why?
Reason 1: Lower volatility
By definition, short duration bonds have a shorter time to maturity, meaning they experience less severe price swings caused by external factors such as the economic backdrop or a company’s earnings outlook. This means that by nature, these bonds exhibit a lower volatility profile than other fixed income instruments, which tend to be more correlated with market movements and investor sentiment. Short-dated bonds also have lower duration risk, meaning they are less sensitive to changes in interest rates. Lastly, as the name depicts, these products have less time to maturity.
So why should this matter for investors? Taking a look at the uncertain, volatile market of today, which will continue well into the new year, investors are looking for ways to gain emerging market exposure, whilst mitigating risk factors associated with these regions. In addition, investors are increasingly more cautious with market correlation and risk appetite, and rightly so, given the current investment landscape. Because of their short-term properties, these products provide emerging market exposure, without investors being susceptible to dramatic ups and downs of interest rate expectations or direct influence of continuous market movements. In addition, short-dated bonds give investors more transparency in terms of the direction of a company’s earnings and liquidity position. The short-term nature of these instruments makes it easier for investors to forecast a company’s ability and willingness to meet their financial obligations, as compared to a forecast on longer-term fixed income products.
Reason 2: Spread premium to developed markets
Relative to short-dated developed market bonds, short-dated emerging market corporate debt provides the potential for an incremental pick-up in credit spread. For example, the average yield of the 1–3-year segment of the J.P. Morgan Corporate Emerging Markets Bond index (CEMBI) is 1.39 per cent for investment-grade issuers and 8.43 per cent for high yield issuers— compared to 0.86 per cent and 6.29 per cent for US investment grade and high yield, respectively.
Despite common perceptions, investors may also be taking less credit risk in emerging market debt than its developed counterpart. As these markets develop, which has been expedited by the pandemic, we are seeing emerging markets put serious effort into sustainable business models. Recently, we have seen corporates clean up their balance sheets and improve their fundamentals. As a result, default rates for emerging market high-yield issuers have declined in recent years. This isn’t to say these investments are low risk by any means, but it does highlight that taking carefully considered, selective risk can help investors earn the yields they need to meet their longer-term return obligations. Particularly as the pandemic has nearly diminished yields, taking a second look at these products are worthwhile.
Reason 3: Better diversification
Emerging market corporate debt is one of the fastest-growing asset classes, expanding from $1trn in 2012 to $2.4trn at the end of 2019. By comparison, the emerging market sovereign debt market is $1.1trn, while US high yield is $1.7trn. This growth has significantly increased the range of investment opportunities there are in the space, across regions, ratings and sectors. Including emerging market corporate debt in a portfolio not only adds diversification in terms of regional exposure, but also opens up various opportunities across sectors and corporate structures.
Historically, emerging market assets were perceived as risky, mainly due to being a traditionally commodity-dominated asset class. However, the emerging market universe has changed, and again, the pandemic has only accelerated this. The asset class has evolved and matured, meaning many emerging market corporates are now global companies with diversified sources of revenue. There is a quiet revolution underway, and the prudent choice for investors is to pay attention to it.
Emerging market corporate debt continues to offer an opportunity to potentially achieve superior risk-adjusted returns and invest in well-diversified companies with robust balance sheets. And going forward, we do not expect to see a widespread spike in defaults in emerging market corporates—thanks to both the stronger fundamentals of these businesses as well as the wave of credit support and liquidity measures being announced by governments and central banks around the world. Not all companies will be impacted to the same extent though, which is why selectivity is so crucial.
Unprecedented times calls for a reconsideration in how we view the world and our investments alike. We are all navigating through the unknown, but sometimes the solution lies in a path once crossed.
Omotunde Lawal is head of emerging markets corporate debt group at Baring Asset Management. The views expressed above are her own and should not be taken as investment advice.