Emerging markets credit: Untapped growth

Emerging markets credit has proven its resilience throughout 2024, navigating both macroeconomic headwinds and regional challenges. A key factor behind this performance has been the proactive policy responses from EM central banks, which, by acting ahead of their developed market counterparts have been able to stabilize growth and control inflation. The early rate cuts create a more favorable environment for corporate debt issuers, strengthening corporate financial positions and lowering default risks.

Over the past decade, emerging market central banks have enhanced their market credibility, allowing greater independence from the Fed in setting policy. This flexibility has enabled EM central banks to respond more effectively to their domestic economic conditions, helping them manage inflation and growth more successfully. As the Fed continues its rate cuts, a softer dollar could further benefit EM markets by appreciating local currencies and reducing debt costs for EM issuers.

EM credit has evolved into a distinct, stand-alone asset class. The JPM Corporate EMBI Broad Diversified index, one of the most widely used benchmarks, has grown to nearly USD 500 billion. However, the broader investment universe for external EM corporates exceeds USD 1.5 trillion, suggesting that strict index rules leave significant portions of the market untapped. This growth has sparked increasing institutional interest, boosting trading volumes, and deepening market liquidity. As a result, investors can find hidden value in segments of the EM credit market that lie beyond standard benchmarks.

A key factor in the growth of emerging markets has been the rise of transition investing, as businesses across emerging markets shift toward more sustainable and resilient models. According to PWC, EM economies could grow around twice as fast as DM economies, and by 2050 six of the seven largest economies will be what we currently consider EM countries¹. The rapid growth of these regions, which account for 65% of GHG emissions and over 80% of the world’s population, brings significant challenges, particularly as they face the most severe impacts of climate change.

From a fixed income perspective there are a couple of instruments available to finance the transition. Green bonds, where the proceeds are exclusively applied to finance eligible climate projects, is a great example. This market is expanding rapidly, especially in emerging markets. Green bond sales in this region has risen nearly 50% year-to-date, highlighting the region’s growing role in sustainable finance.

An alternative is to select companies that are at the beginning of their journey to combat climate change. Investments in hard-to-abate sectors, like energy, materials, and utilities, are needed if we want to decarbonize and limit global temperature rise. Any company that is currently preparing for a low-carbon future will have a significant advantage over those that are not. Using our proprietary forward-looking IP allows us to pinpoint companies that have credible plans to eventually reach net zero in 2050. A good example is a Mexican cement producer, which at this point is perhaps too dirty, but has the right investments in place to be one of the market leaders in driving the transition. Selecting these types of investments not only drives our ability to transition, but also to generate the best risk-adjusted returns possible. We have strategically positioned our EM strategies as transition-focused to align with these emerging trends.

However, the impact aspect of EM credits is not the only story. Here we unpack the many opportunities for investors within this asset class.

Emerging market companies are often underrated relative to their strong fundamentals. This is partly due to the country ceiling approach used by rating agencies, which caps a company's credit rating based on the sovereign rating of its home country, regardless of the company’s financial robustness. As a result, many high-quality emerging market companies are assigned lower ratings than their balance sheets suggest, creating an opportunity for investors to capture higher yields.

This is why emerging markets corporate bonds (CEMBI Broad Div) offer better risk-adjusted returns than developed market bonds, as demonstrated by higher Sharpe ratios, stronger cumulative returns, and relatively favorable annual returns, despite higher volatility. Figure 1 illustrates that over the long term, emerging markets credit proves more attractive than other credit asset classes, delivering consistently strong performance.

Despite facing two major downturns in the past decade — Latin America's commodity crisis in 2015 and Asia's property bust in 2020 — emerging markets have demonstrated resilience through stronger, proactive policies and corporate deleveraging. These events have also highlighted the disconnection between emerging market economies and developed markets, as well as within EM regions. While Asia thrived during the commodity crisis, Latin American credits outperformed during Asia’s slowdown. This shows the significant diversification benefits of emerging markets credits, making them a compelling asset class for investors seeking both stability and growth potential.