How to make sense of Emerging Market Debt in a global portfolio

December 4, 2024

Damien Buchet, CFA

Chief investment officer, Principal Finisterre

Emerging market debt (EMD) has garnered increasing attention from investors for many years. While the asset class has historically delivered attractive, diversified returns driven by high income generation, many investors still need help understanding how to approach it effectively. However, for those considering EMD investments today, despite potential short-term volatility stemming from geopolitical events, we believe the current environment presents one of the most favorable opportunities in the past decade.

The short-term EMD macro landscape has rarely been this favorable

The recent U.S. election has been a key factor of near-term volatility in EMD. However, like Trump’s first presidency, there may be a silver lining for a large part of the EMD universe. President-elect Trump’s likely weaponizing of tariff and trade actions will prioritize China, followed by Mexico, the EU, and potentially Southeast Asia—a region through which many Chinese exports to the U.S. have been rerouted since 2018. While China is expected to face significant tariffs first, Trump’s recent discussions with Mexico’s new president suggests that there are opportunities for other nations to negotiate deals in exchange for tariff clemency. Global investors also should note that debt issuers from regions like Latin America, the Middle East, Africa, Eastern Europe, Turkey, and the Indian subcontinent either largely remain outside of the scope of currently proposed U.S. trade actions or maintain favorable relations with the U.S.

While there were some initial concerns over widening U.S. deficits from proposed unfunded tax cuts, which could pressure the Federal Reserve to keep monetary policy tight, the nomination of Scott Bessent for Treasury Secretary (and the fact that there is ample market liquidity, eager to purchase U.S. T-bills) has eased some market angst. We expect that EMD flows will rebound in the new year, especially post-inauguration, once there is further clarity on policy and election-related EM volatility subsides.

The prospect of Trump’s presidency is also accelerating efforts to resolve ongoing global conflicts. In the Middle East, Israel's recent and decisive actions have pushed Iran into a defensive position, a shift that many Arab states quietly agree with. While risks of disrupted oil production in Iran and the Gulf remain, any disturbances are expected to be short-lived. Notably, Iran's weakened stance may lead investors to price in extended stability in the region, once the period of acute fighting in Lebanon and Gaza subsides. Similarly, in Ukraine, positions on both sides have started to shift towards the need for some form of cease-fire, though skepticism about the durability of any agreement remains high.

Finally let’s not forget that three of the world's major central banks remain in easing mode—the Fed, the European Central Bank and the People's Bank of China—providing liquidity support to risk assets and the aggregate global economy. Easier monetary policies and a possible soft landing of the U.S. economy (consensus forecasts point to 2% growth for 2025 vs. 3% for 2024) should revive appetite for emerging markets debt through improving global financial conditions, and stabilization in the very strong recent USD move. That, coupled with ultra-low global positioning, the perception of EMD offering widespread risk diversification, an attractive income stream, and more “value for money” versus the actual risks, in a world of richly valued developed market (DM) equities and credit assets, should support interest for EMD. This should continue to create conditions for a “grind tighter” in credit spreads and a progressive top in USD strength, allowing for a combination of a 7-9% income stream and some capital gains into 2025. Market participants may be wise to reallocate to EMD strategically through any dips ahead of and immediately after the passing of the New year.

Complexity can be a challenge

Most international fixed income segments are in some way a blend of sovereign USD credit, corporate USD credit, and local currency sovereign bonds. But EMD adds additional layers of complexity, making it one of the most tangled global asset classes available to retail and institutional investors. It is influenced by global macro developments (including U.S., European, and Chinese economic activity, commodity markets, and global liquidity conditions) as well as the bottom-up idiosyncrasies of individual developing countries and corporates that offer a variety of macro situations, political wrinkles and business models.

Complexity plays out technically, too. There are many types of global investors interacting in EMD, ranging from domestic to international investors, mutual funds, pension funds, sovereign wealth funds, insurers, hedge funds, etc., each with their unique risk and return considerations, investment biases, and time horizons.

Emerging markets often grab attention with dramatic headlines, which can paint a picture of instability. From sudden defaults and financial crises to political unrest and ESG mishaps, these issues can make it challenging to reassure investment board members or clients about the merits of investing in these regions.

Adding to the difficulties, the last five years have been tough for all fixed income asset classes. Emerging Market Debt has been especially volatile, impacted by various challenges, including the COVID-19 pandemic, rising inflation, aggressive central bank tightening, and ongoing geopolitical tensions and conflicts.

Negative sentiment has left EMD under-owned

As a result of the challenging and volatile conditions of the past few years, investors redeemed their emerging market debt holdings throughout 2022 and 2023, in the largest outflow since 2008. Furthermore, despite the recent global surge in demand for fixed income, global investors have remained spooked by EMD and have stayed on the sidelines since late 2023, resulting in the asset class being deeply under-owned. Once investors recognize the more constructive fundamental backdrop for EMD assets, however, the under-owned nature of the asset class could be a favorable technical factor for the sector.

In fact, the fundamental picture of EMs ex-China has been remarkably resilient, with growth trending around 3.0-3.5% annualized, yoy, for 2024, up from 2.5% in early 2023. Inflation challenges in many EMs were also contained earlier than in most DMs, thanks to a much more decisive tightening by EM Central Banks starting in early 2021. Additionally, commodity prices have remained in a “Goldilocks” trading range for EM countries, and fiscal balances remain broadly sound, supporting many EM economies. Despite prospects of lower oil prices into 2025, oil between $70-$80/bl is not too expensive to cause a balance of payments challenge for importers, while not being so cheap for exporters so that it causes major fiscal pressures. With Federal Reserve rate-cutting cycle coinciding with a measured slowdown in U.S. activity and a much brighter environment for EMD may be on the horizon.

Income should remain the driver of EMD returns

For many investors, the conventional path into EMD, through benchmarked funds or ETFs, has not recently yielded significant rewards. In fact, over the past two decades, while investors have earned an attractive and diversified income stream, this has been accompanied by substantial volatility, including numerous instances of capital loss.

Consider that since 2003, the income generated by the JP Morgan EMBIG Div Sovereign USD index and the JP Morgan GBI-EM Local Currency Bond index has, on average, accounted for nearly all of their annualized returns, while the price components of those indices have been relatively trendless.

As the income stream has remained relatively stable despite declining global bond yields and given that EMD indices have shown significant volatility and little to no capital gains over the past 20 years, looking ahead, delivering that income should remain the anchor of returns in both hard and local currency assets.

Average annual income vs. capital gain return
2003–2023

Source: JP Morgan, Principal Finisterre. Data as of December 31, 2023. Hard currency sovereign bonds is represented by the JP Morgan Emerging Market Bond Index Global Diversified, local sovereign currency bonds is represented by the JP Morgan Government Bond Index - Emerging Markets.

Annual capital returns from EM sovereign external and domestic debt indexes
2003–2023

Rethinking EMD exposure

The recent surge in demand for global credit funds, primarily driven by U.S. investors, and which typically includes an allocation to EM Debt of 15% to 30%, has been one indirect way for investors to gain exposure to EMD. However, it's important to exercise caution as this approach is highly restrictive. It typically focuses on a small and richly valued sub-segment of EMD, essentially BBB/BB USD sovereigns and quasi-sovereign credits, and/or a small sample of large but what we see as less attractive local markets from Asia or Central Europe. Moreover, the typical managers of such funds often lack deep specialization in EMD and tend to adopt a classic benchmarked or semi-passive approach, which does not address the investment challenges facing EMD investors today.

Investors deserve a different approach—one that emphasizes the underlying strengths of the asset class: delivering diversified income and providing a significant source of uncorrelated alpha from diverse economic scenarios across countries, (including frontier markets, restructuring opportunities, relative value plays in FX or rates) and EM corporate issuers.

Effective beta management, or the strategy of “buying low and selling high” with minimal transaction costs, should also be integral. This enables EMD managers to capture market upside without being fully exposed during downturns. When managers prioritize investing on genuine convictions rather than being constrained by index weights, it can enable them to provide an attractive income stream with an asymmetric upside/downside capture ratio and a lower volatility profile compared to most EMD indices, ETFs, or single asset class benchmarked funds.

Principal Finisterre

A manager’s freedom to act on their true convictions, rather than being biased by index weights, is the essence of the “Total Return” approach that Principal Finisterre has been developing over the market cycles of the past 11 years. In doing so, we are trying to provide an attractive income stream, with an asymmetric upside/downside capture ratio and an overall lower volatility profile than most EMD indices, ETFs or single asset class benchmarked funds.

We believe this approach has been and will continue to be, an optimal way to reap the real benefits of exposure to emerging market debt. It enables income enhancement combined with an EMD manager’s ability to express strong convictions independently of index weights and generate alpha generation from specific EM situations or market timing. The ultimate objective of which is to capture the broad index upsides for a fraction of the downsides with moderate volatility.

Find out more: https://www.principalam.com/eu/principal-finisterre-emerging-markets-debt-total-return-strategy

Fixed income

Macro views

Disclosure

Risk considerations
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. International investing involves greater risks such as currency fluctuations, political/social instability, and differing accounting standards. Emerging market debt may be subject to heightened default and liquidity risk. Risk is magnified in emerging markets, which may lack established legal, political, business, or social structures to support securities markets. Fixed Income investments are subject to interest rate risk; when interest rates rise, the price of debt typically declines. International investing involves greater risks such as currency fluctuations, political/social instability, and differing accounting standards.

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"These Terms & Conditions explain certain legal and regulatory conditions and restrictions in relation to the Principal Global Investors (Europe) Limited website, and in relation to the Principal Global Investors Funds (‘the Funds’). This information may be changed by Principal Global Investors at any time without notice.

In these terms and conditions, references to 'Principal Global Investors' means Principal Global Investors (Europe) Limited or any affiliate of the Principal Financial Group, Inc. or Principal Global Investors, LLC.

Before you proceed, you must acknowledge that you have read, and agree to, our terms and conditions.

Information in relation to the Principal Global Investors Funds is available through this web site to institutional investors resident in the following countries of: Belgium, France, Finland, Germany, Guernsey, Ireland, Italy, Jersey, Netherlands, Spain, Sweden, Switzerland and the United Kingdom. By proceeding this far you are representing and warranting that you are an institutional investor resident in one of these countries. Not all of the Funds are available in all these jurisdictions, and investors are directed to the Country Registration document for detailed information. What follows is not an offer or invitation to acquire an investment to, and should therefore not be relied upon by, any person anywhere other than the countries noted. Persons in respect of whom such prohibitions apply must not access this web site. This web site is reserved exclusively for non-U.S. persons and should not be accessed by any person in the United States.

Yes, I certify to be an institutional investor and resident of a country listed above.

Cookies
Use of cookies on this site is outlined in the Privacy and Security Policy. In accepting these terms and conditions, you accept the terms of the Cookie Policy and the use of cookies from this site.

Legal Entity Disclosure and Regulation
In Europe by Principal Global Investors (Ireland) Limited, 70 Sir John Rogerson’s Quay, Dublin 2, D02 R296, Ireland. Principal Global Investors (Ireland) Limited is regulated by the Central Bank of Ireland.

In the United Kingdom by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London, EC2V 7 JB, registered in England, No. 03819986, which is authorised and regulated by the Financial Conduct Authority (“FCA”).

In Switzerland by Principal Global Investors (Switzerland) GmbH. This website is considered as advertising and information contained herewith be treated as such. Investors can obtain free of charge the prospectus, trust deed, the prospectus, the key investor information document (KIID), and the annual and semi-annual reports from the representative in Switzerland.

In Europe and United Kingdom, this website is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by the MiFID and FCA respectively). If you are viewing the material as a retail investor, you should seek independent investment advice before deciding whether the products and services in question are suitable to meet your investment needs and objectives, as the language has not been complied to a retail client standard.

Principal Global Investors Funds
Principal Global Investors (Ireland) Limited is the issuer of the Funds. Investments may only be made on an application form attached to a current prospectus and following receipt by the investor of the KIID in respect of the Fund in which they intend to invest. The latest version of the prospectus of the Funds is dated 14 December 2012.

For Real estate investors in the European Economic Area (“EEA”), this website and the information on it is only directed at persons who are professional investors for the purposes of the Alternative Investment Fund Managers Directive (2011/61/EU) (“AIFMD”), professional clients or eligible counterparties for the purposes of the Markets in Financial Instruments Directive (Directive 2014/65/EU) (“MiFID II”) or as otherwise defined under applicable local law and regulation and at whom this website and the information on it may lawfully be directed in any relevant jurisdiction (“Eligible Persons”). In relation to each member state of the EEA (“Member State”) which has implemented AIFMD (and for which transitional arrangements are not/ no longer available), this website may only be accessed and interests in Funds may only be offered or placed in a Member State to the extent that: (i) the relevant Fund is permitted to be marketed to professional investors in the relevant Member State in accordance with AIFMD (as implemented into the local law/regulation of the relevant Member State); or (ii) this website and its information may otherwise be lawfully distributed and the interests in Funds may otherwise be lawfully offered or placed in that Member State (including at the initiative of the investor). In relation to each Member State of the EEA which, at the date of accessing this website, has not implemented AIFMD, this information may only be distributed and interests in Funds may only be offered or placed to the extent that this information may be lawfully distributed and the interests in Funds may lawfully be offered or placed in that Member State (including at the initiative of the investor).

Persons who are not Eligible Persons, including but not limited to those individuals or other persons who fall within the FCA’s definition of ‘retail clients’, should not use or rely upon this website or the information contained therein and may not engage the services of Principal Real Estate or any of its affiliates, or invest in any Fund. Potential investors are advised that all or most of the protections provided by the UK regulatory system will not apply and that the UK Financial Services Compensation Scheme may not be available in relation to an investment in a Fund or separate account.

The contents of this website have not been verified or approved by any competent regulatory or supervisory authority. No liability, whether in negligence or otherwise, arising directly or indirectly from the use of the information or any part of it on this website is accepted and no representation, warranty or undertaking, whether express or implied, is or will be made at any time by Principal Real Estate or its affiliates or any of their respective advisers, directors, officers, employees, representatives or other agents (“Principal Agents”) for any information or any of the opinions contained herein or for any errors, omissions or misstatements.

None of Principal Real Estate or its affiliates or any Principal Agents makes or has been authorised to make any representation or warranties, whether express or implied, in relation to Principal Real Estate or regarding the truth, accuracy or completeness of any of the information contained on this website at any time. No representation or warranty is given by Principal Real Estate, its affiliates or the Principal Agents as to the achievement or reasonableness of, and no reliance should be placed on any projections, targets, estimates or forecasts contained in the information on this website. Furthermore, nothing contained on this website is or should be relied on as a promise or representation as to the future. No reliance may be placed by any person for any purpose whatsoever on the information or opinions contained on this website or on its completeness, accuracy or fairness at any time.

Principal Global Investors (Europe) Limited is not authorised by the FCA to directly deal with retail investors; any distribution of the Fund to retail investors in Europe is facilitated by fund distributors with which Principal Global Investors (Europe) Limited has entered distribution arrangements, pursuant to advice provided to investors by those distributors, based on the documents Principal Global Investors (Europe) Limited provides. Retail investors should not be provided with access to this website.

The name of the Swiss representative is ACOLIN Fund Services AG, Stadelhoferstrasse 18, CH-8001 Zürich. The name of the Swiss paying agent is Banque Cantonale de Genève, 17, quai de l’Ile, 1204 Geneva. Investors can obtain the prospectus, trust deed, the simplified prospectuses and the annual and semi-annual reports free of charge from the representative in Switzerland.
The value of units and the income from them may fall as well as rise.

Investments in the Funds are neither insured nor guaranteed by the US Government or the Federal Deposit Insurance Corporation and are not deposits or obligations of, or guaranteed by, Principal Global Investors.

No Solicitation
Nothing contained in this website shall constitute an offer or solicitation, in relation to units in the Funds or generally, in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorised.

In particular, shares issued by the Company, and units in the Funds, have not been and will not be registered under the United States Securities Act of 1933 as amended or the securities laws of any state or political subdivision of the United States and may not, except in a transaction which does not violate US securities laws, be directly offered or sold in the United States or to any US Person. The Company will not be registered under the United States Investment Company Act of 1940 as amended.

This website is reserved exclusively for non-US persons and should not be accessed by any person in the United States.

No Investment Advice
The information in this website contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such nor should it be construed as specific investment advice, an opinion or recommendation. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. Past performance is not a reliable indicator of future performance and should not be relied upon as a significant basis for an investment decision.

You should also inform yourself as to (a) the possible tax consequences, (b) the legal requirements and (c) any foreign exchange restrictions or exchange control requirements which you might encounter under the laws of the countries of your citizenship, residence or domicile and which might be relevant to any investment, including the subscription, holding, transfer or disposal of units in the Funds

Delegation of Investment Management to Affiliates

Products upon which composite results contained in this material, if any, are based may not themselves be available in the United Kingdom and certain other jurisdictions; however, the underlying investment management capability can be made available to institutional investors subject to all applicable local regulations and restrictions. In connection with its management of client portfolios, PGIE may delegate management authority to affiliates that are not authorised and regulated by the Financial Conduct Authority. In any such case, the client may not benefit from all protections afforded by rules and regulations enacted under the Financial Services and Markets Act 2000.

Disclaimer
The information on this website is given by Principal Global Investors in good faith and has been derived from sources believed to be reliable and accurate as at their date. However, Principal Global Investors makes no representation or warranty of any kind for the accuracy or completeness of the information and it is under no obligation to update or correct any errors in the information after the date of publication. This website also contains videos where the comments were valid on the date the video was recorded. Markets move continuously and you should only rely on current information for any investment decisions.

Subject to applicable law, Principal Global Investors and its affiliates and their respective directors, employees and associates do not accept any responsibility arising in any way (including by reason of negligence) for errors in, or omissions from, the information and do not accept any liability for any loss or damage, however caused, as a result of any person relying on any information on the website or being unable to access the website.

The Internet is not a totally reliable and secure medium of communication. Principal Global Investors accepts no liability for the security or confidentiality of information transmitted in this way and any such transmission of information shall be at your own risk.

The entire content of this website is subject to copyright with all rights reserved. You may not copy, reproduce, distribute or modify the content of this website without the prior written permission of Principal Global Investors.

No instructions for investment purposes will be accepted directly from this website or by e-mail.

If you accept these terms and conditions, click “Accept.”

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You may view, download for caching purposes only, and print content from the website for your own personal use, subject to the restrictions set out below and elsewhere in these Terms of Use.

No Guarantee of Timeliness
This website may contain videos where the comments were valid on the date the video was recorded. Markets move continuously and you should only rely on current information for any investment decisions. The information and materials contained on this website, and the terms, conditions, and descriptions that appear, are subject to change. All content on this website is presented only as of the date published or indicated, and may be superseded by subsequent market events or for other reasons. In addition, you are responsible for setting the cache settings on your browser to ensure you are receiving the most recent data.

No Warranties
The information on this website has been developed internally and/or obtained from sources believed to be reliable; however Principal Global Investors and its affiliates do not independently verify or guarantee its accuracy or validity. The information and services provided on this website are provided ""AS IS"" and without warranties of any kind, either expressed or implied. To the fullest extent permissible pursuant to applicable law, Principal Global Investors disclaims all warranties, including, but not limited to, any warranty of non-infringement of third-party rights and any implied warranties of merchantability and fitness for a particular purpose. Principal Global Investors does not warrant, either expressly or impliedly, the accuracy or completeness of the information, text, graphics, links or other items contained on this website and does not warrant that the functions contained in this website will be uninterrupted or error-free, that defects will be corrected, or that the website will be free of viruses or other harmful components. Principal Global Investors expressly disclaims all liability for errors and omissions in the materials on this website and for the use or interpretation by others of information contained on the website. Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions on this website.

If you have questions, please email us.

Click ""Accept"" to indicate your acknowledgement and acceptance of Principal Global Investors Terms of Use and to continue."

This website contains general information only on investment matters and nothing in this website is intended to constitute or form part of any offer or inducement to issue or sell, or any solicitation of any offer to subscribe for or purchase, any securities or investment products in the UAE (including the Dubai International Financial Centre) and accordingly should not be construed as such. Information in this website is not directed at you if we are prohibited by any law of any jurisdiction from making the information on this site available to you and is not intended for any use that would be contrary to local law or regulation. Products or services mentioned on this site are subject to legal and regulatory requirements in applicable jurisdictions and may not be available in all jurisdictions. Accordingly, persons are required to inform themselves of and observe any such restrictions.

The information in this website is being made available on the basis that the recipient acknowledges and understands that the entities and securities to which it may relate have not been approved, licensed by or registered with the UAE Central Bank, the Dubai Financial Services Authority or any other relevant licensing authority or governmental agency in the UAE or elsewhere in the Middle East.

The information in the following website should not be construed as investment advice or a recommendation for the purchase or sale of any security. The value of investments and the income from them may fall as well as rise. Principal Investor Management (DIFC) Limited and the other member firms of Principal (collectively, the “Firms”) do not guarantee any investment results and there can be no assurance that the strategies employed will improve investment performance, and make no guarantee that a client’s investment objectives will be achieved and no warranties or representations, expressed or implied, are made by the Firms concerning the benefits of these strategies discussed herein. The information in this website has been developed internally and/or obtained from sources that the Firms believe to be reliable; however, the Firms do not guarantee the accuracy, adequacy or completeness of such information and are not responsible for any errors or omissions. This website also contains videos where the comments were valid on the date the video was recorded. Markets move continuously and you should only rely on current information for any investment decisions.

This website contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The information it contains does not take account of any investor’s investment objectives, particular needs or financial situation. Past performance is not a reliable indicator of future performance and should not be relied upon as a significant basis for an investment decision. You should consider whether an investment fits your investment objectives, particular needs and financial situation before making any investment decision.

Nothing in this website should be construed as investment, tax, legal or other advice.

The content of this website has not been approved by or filed with the UAE Central Bank or Dubai Financial Services Authority.

Access to this website is only permitted for “Professional Clients” as defined in the Conduct of Business of the Dubai Financial Services Authority’s Rulebook. If you are not a “Professional Client”, you may not access this website and you should select the “Decline” link below.

By selecting the “Accept” button below, and entering this website, you agree to these terms and confirm and represent that you are a “Professional Client”.