1. In High Regard

    What’s right with Emerging Market Government Bonds

    James Squires, Investment Manager
  2. All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk.

  3. The South Sea Bubble. The Brady Plan. The Russian default. Venezuela. Everyone knows that lending to emerging markets is risky. Indeed, most US pension funds currently have less than one per cent of their assets in emerging market government bonds. Yet historically, our multi-asset funds have had a 10–20 per cent allocation. Why? Well, we believe that emerging market government bonds is an important and attractive asset class for diversified multi-asset funds. The out-of-date negative perceptions and persistent prejudice that surround the asset class means that for genuinely active managers, emerging market government bonds can provide great opportunities to add value, while also being attractive from the point of view of portfolio diversification. Let’s take a closer look at this asset class and dispel some of the common misconceptions that surround it.


    Emerging market government bonds are sovereign debt instruments issued by the governments of emerging market countries. They can be issued either in the local currency or in a major international currency (usually US dollars). While we invest in both forms, we tend to prefer local currency bonds, which typically offer a higher yield and may benefit from real currency appreciation.

    The first misconception that surrounds EM government bonds is exactly what countries we are talking about. JP Morgan’s GBI EM Global Diversified index (henceforth, GBI-EM) is the most well-followed index of local currency debt issuing countries. Its constituents are quite different from the countries that are representative of Emerging Market equity indices and which are generally understood as ‘EM’. Within equity indices, the largest four constituent countries are China, India, Korea and Taiwan (collectively over 60 per cent of the MSCI EM Equity Index), yet none of these countries feature in the GBI-EM Index.

    The GBI-EM is a well-balanced index. Geographically, it is split equally across Latin America, Emerging Europe and Africa/Asia, with a good balance of commodity importers and exporters. These are countries that are making real progress, both politically and economically, and are far removed from the countries which were associated with emerging market lending in the past.

    In contrast to many developed markets, most of these countries have Fiscal Responsibility Laws that limit their government’s expenditure, resulting in national debt which averages out at less than 50 per cent of GDP (as compared to over 100 per cent in the advanced economies). Additionally, currency reserves tend to be high, reducing the net debt burden further, to around 40 per cent. This all means that the GBI-EM index consists of a very creditworthy set of countries, as reflected in the index’s BBB average rating.

  5. Issuing in Local Currencies

    While emerging market countries are no strangers to issuing debt, it is only relatively recently that countriesí bonds have begun to be issued in their local currencies. Historically, it was more common to see issuance in an external (or ëhardí) currency, often US dollars. As recently as 2002, there was less than $1 trillion of emerging market local currency sovereign debt outstanding. However, there has been a substantial growth in issuance over the last 20 years, taking the universe to more than $10 trillion today.

    This growth has had important implications: it has made the asset class easier to invest in, and it has also helped improve the creditworthiness of the issuing countries. Swapping external debt issuance for local currency issuance means that countries avoid the ëoriginal siní of relying on foreign currency borrowing to finance domestic projects. This practice not only increased currency mismatches, but made their economies far more vulnerable to financial crises if the currency depreciated, as witnessed in numerous previous defaults and crises. Within our multi-asset portfolios we invest in both local and hard currency EM bonds. Investment Manager, John Berry, discusses our approach to hard currency EM bond investing below, in the section In Focus – Emerging Market Hard Currency Bonds.


    In aggregate, emerging markets have lower debt levels and faster growth…

    Government Gross Debt/GDP





    Source: IMF. World Economic Database, October 2019.


    Real GDP Growth





    Source: IMF. World Economic Database, October 2019.


    …And there is clear evidence of structural improvements


    Current Account Balance (Emerging market and developing economies)






    Source: Bloomberg, displaying the 10 largest constituents of the JP Morgan GBI-EM Global Diversified Composite Index. Full year 2013 and 2018. Data sourced November 2019.


    Average Inflation




    Source: Bloomberg. Average inflation based on the Emerging Economics Consumers Price Index. Full year 2013 and 2018. Data sourced November 2019.








    The next misconception to address is with regard to the risk/return profile. What makes emerging market government bonds a compelling investment for multi-asset funds is a combination of both the return and risk profile. We believe both that the returns on offer from this asset class are attractive and that the risks are typically diversifying to a multi-asset portfolio, that is, we expect less correlation with equity markets.

    The GBI-EM, an index of investment grade quality government bonds, has tended to yield around 6 per cent. This is substantially above the yields currently on offer from developed market government and investment grade indices. Plus, it is reasonable to hope for capital appreciation on top of that. As the countries in the GBI-EM index mature further, yield levels should converge towards those prevalent in the developed markets, suggesting that international pension funds may increase their allocation to the asset class over time. Additionally, we would expect to see real appreciation from EM currencies over the long term.

    This combination has already proven a powerful one. Emerging market government bonds have returned 7–8 per cent p.a. over the full life of the index and losing money has been a rarity. Over its history, the GBI-EM has suffered a negative return in local currency in only 4 per cent of the rolling twelve-month periods and the worst drawdown has been a reasonably modest 6 per cent.


    US Treasury Yield vs EM Bond Index Yield




    Source: Bloomberg and JP Morgan.



  8. The unhedged return experience has been different for each base currency against which it is measured. Emerging market currencies have tended to be quite volatile when set against the US dollar, but less so when set against a broader basket of developed market currencies (and particularly when the dollar is excluded from that basket). In our multi-asset funds, we typically choose to retain the emerging market currency exposure that emerging market government bonds give us, but set that long position against a basket of short positions from across the advanced economies. Doing so reduces that aforementioned volatility.

    Within our multi-asset portfolios today, we have a combination of local and hard currency exposure. This provides further diversification to our exposure to this asset class. We adjust our asset allocation accordingly to reflect the attractions and valuations of both Emerging Market Bonds and also the other asset classes within our broad investment universe. Recently we have been reducing our overall allocation as yields have fallen.


    Multi Asset allocation to Emerging Market Government Bonds



    Source: Baillie Gifford & Co.







    What do China, Senegal, Tajikistan, Mexico, Argentina, Indonesia and Turkey have in common? Not much – they vary enormously in size, population, demographics, wealth, economic structure, climate and history. Yet they all belong to the universe of Emerging Market ‘hard currency’ (EMHC) debt issuers, i.e. countries which have issued debt instruments denominated in dollars or euros.

    Not entirely coincidentally, they have also all been visited by Baillie Gifford investors in the last year in our search for good sovereign debt investments. We’re looking for countries where we think there’s a very high probability that they pay back their debts, and where the yields more than compensate us for the risk that they don’t pay us back. There are myriad factors influencing this, from issues within the country’s control to global trends over which they may have little power. However, like our colleagues elsewhere in Baillie Gifford, we place a strong emphasis on sustainable growth. This is because where a government borrows to invest productively in human capital or economic infrastructure, higher growth should increase fiscal revenues, allowing the original loan to be repaid. As such, there is a significant and obvious correlation between a country’s economic development and the probability it will successfully repay its loans.

    Over the last two decades, emerging market hard currency debt has delivered an average return of 9 per cent per annum, compared to annual average return of 4.5 per cent for US Treasuries over the same period1. While there has been a degree of correlation with other ‘risky’ asset classes, such as Emerging Market local currency debt, corporate credit and equities, there has been enough difference to make our investment in EM hard currency bonds a useful diversifier relative to these asset classes.

    EM hard currency bonds are issued by more than 70 emerging market sovereigns, as well as many state-owned enterprises.

    One of the most commonly used indices is JP Morgan’s Emerging Market Bond Index Global Diversified, about half of which is rated investment grade and the other half rated high yield.

    Most EMHC bonds are issued in US dollars, although some are denominated in euros. As such the key risk is default, rather than inflation or currency depreciation.

    Bonds tend to have a maturity of between 5 and 30 years at issue and an issue size of at least $500 million. Secondary market liquidity varies widely, with the transaction cost when opening or closing a position varying from 0.25 per cent to 0.75 per cent of the price.

    1. For JP Morgan’s ‘Emerging Market Bond Index Global – Diversified’ and for Treasuries of a similar maturity to the EM bonds in this index.


    Importantly, from the perspective of a multi-asset fund investor, the attractive returns available in Emerging Market debt are delivered differently to those in other mainstream asset classes, such as equities.

    This is because what drives the returns of an individual country’s bonds is far more likely to be related to local political and fundamental factors than it is the global economy. Investors in EM government bonds care about government policy; reforms; commodity exposures; central banks’ attitudes and this is what gets priced into the currencies and yield curves. India, for example, remains a relatively closed economy, so the Indian bond market is far more concerned about the level of inflation and the ability of premier, Nahindra Modi, to implement genuine reforms and ensure fiscal responsibility than it is about growth in the United States, or President Trump’s latest tweet.


    Dispersion of Country Returns Increases with Time




    Source: Bloomberg.

    What this means is that there is only limited correlation between EM debt and other asset classes. Statistically, the GBI-EM index has shown a correlation (R) of just 30 per cent and a beta of just 0.1 to global equities over the long term. In practice, emerging market government bonds have made money in 87 per cent of the rolling twelve-month periods in which global equities have fallen, with an average return of 5 per cent. Notably, as can be seen in the chart opposite, during the Global Financial Crisis of October 2007 to March 2009, global equities fell by 54 per cent whereas EM local currency bonds delivered a positive return of 1 per cent2.

    2. Global equities represented by the MSCI World Index in local currency. EM local currency bond return is unhedged vs GBP/AUD/EUR/JPY equally weighted as recently expressed in our Multi Asset portfolios.

    EM Local Currency Bond Index During Five Largest Equity Market Declines Since 2003




    Source: Bloomberg, JP Morgan and MSCI. JP Mogan EM Global Diversified Index. Return shown is unhedged vs GBP/AUD/EUR/JPY, equally weighted as recently expressed in our Multi Asset portfolios. Global Equities: MSCI World.



    So, while some investors continue to be wary of the asset class, mainly based on outdated misconceptions about how risky such investments are, we think such fears are overdone and EM government bonds deserve their place in a well-diversified multi-asset fund. The countries represented in our investable EM bond universe tend to have solid fundamentals and higher yields than international markets, and, by blending them with other hard currency EM government bonds, genuinely active managers can add value over time, while also benefitting from the limited correlation between EM debt and other asset classes.





    The views expressed in this article are those of James Squires and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

    This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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  12. James Squires

    Investment Manager

    James is an Investment Manager in the Multi Asset Team and a member of the Investment Risk Committee. He became a Partner in 2018. James also Chairs the Multi Asset and Fixed Income Review Group. He joined Baillie Gifford in 2006, initially working in our North American Equity and Fixed Income Teams. James has been a CFA Charterholder since 2010 and graduated BA in Mathematics and Philosophy from the University of Oxford in 2005.

  13. John Berry

    Investment Manager

    John joined Baillie Gifford in 2009 and is an Investment Manager in the Emerging Markets Debt Team. Prior to joining Baillie Gifford, he spent eight years working for businesses and aid agencies in Emerging Markets. He graduated MA in Geography from the University of Edinburgh in 1999 and MSc in Development Practice from Oxford Brookes University in 2003.