Investors still too often view emerging market debt (EMD) as a simple choice between hard and local currency. That’s a missed opportunity, said Cathy Hepworth, who established PGIM Fixed Income’s EMD team 30 years ago. According to her, the true strength of the asset class lies in its diversity.
Cathy Hepworth, head of EMD at PGIM, launched the firm’s EMD activities in 1995 together with David Bessey. Since then, the asset class has grown tremendously: government and corporate bonds from emerging markets now represent over 8,000 billion dollar, accounting for around 11 percent of the global bond market.
Local currency EMD in particular has surged and now makes up the majority of the universe. The widely tracked JP Morgan GBI Global Diversified Index includes 19 countries, with China, India, Indonesia, and Mexico each holding a 10 percent weight. This makes the index much more concentrated than the hard currency universe, which includes 70 countries. Still, Hepworth believes the risk profile of the local currency index has improved. “Ten years ago, there were only 10 countries in the local currency index. Now it’s mainly composed of large, less volatile markets.”
As the asset class has grown, so has its resilience. “We saw that after the outbreak of the Covid-19 pandemic, when emerging markets had to stimulate their economies and were able to do so via their local bond markets,” Hepworth explained. As a result, countries like China and India have become less dependent on foreign investors and have gained more flexibility in setting their own monetary policy. Emerging markets, for example, raised policy rates more quickly after the pandemic than Western central banks.
Flexibility is ‘crucial’
Hepworth considers the wide range of investment opportunities one of the most attractive features of EMD. “Most investors have a mix of local and hard currency bonds. Or they track a hard currency benchmark but still want the flexibility to invest across local currency segments,” she said. “That flexibility is crucial when, like us, you pursue a bottom-up approach to generate alpha. Depending on the macro environment, you might want to emphasize hard currency at times and local currency at others. At the end of 2023, for instance, we saw investor risk appetite increase in anticipation of a more accommodative monetary policy in the US. That triggered a rally, particularly in higher-yielding hard currency EM bonds.”
Still, many European investors continue to view EMD primarily as a choice between hard and local currency, Hepworth noted. She advocates approaching it as an integrated asset class. “Emerging markets differ greatly when it comes to demographics, geopolitical risks, financial stability, and trade policy. These differences make it even more important to consider the full spectrum of EMD. Investors who focus on just one segment are missing opportunities. Unfortunately, the belief that EMD should be approached with a narrow lens remains widespread among European investors.”
Structural dollar weakness
Local currency EMD has underperformed over the past 15 years, largely due to the strength of the US dollar. According to Hepworth, the US experienced a period of economic exceptionalism during that time: “US economic growth consistently outpaced the rest of the world, including many emerging markets. That led to a prolonged appreciation of the dollar, putting pressure on emerging market currencies. As a result, returns on local currency EMD lagged, while hard currency EMD held up relatively well.”
The dollar’s strength was driven by cyclical factors, but Hepworth believes the recent weakness is more structural. She pointed to the rising US fiscal deficit and the unpredictable trade policy under Trump. “Investors are reducing their exposure to US assets, and we’re seeing that reflected in strong inflows into local EM bond ETFs. The prevailing view is that Americans will bear the cost of higher import tariffs, while the rest of the world will continue trading with each other.”
Since the start of the year, EM local currency bonds are up 12.4 percent, compared to 6.0 percent for JP Morgan’s hard currency EMBI Global Diversified Index. The hedged version, which neutralizes dollar exposure, has returned 4.56 percent. The currency component can therefore boost returns, but it also introduces volatility. Hepworth: “With tactical positions, investors can take advantage of this dynamic, while the diversification benefits make EMD attractive for a strategic allocation.”
Hepworth also sees opportunities for local currency EMD in the second half of the year. She believes the US dollar is overvalued and likely to remain weak, while many local currencies are still undervalued. “Local currencies are expected to continue performing well, thanks in part to stronger growth relative to developed markets and ongoing capital inflows—from both investors and foreign direct investment. And for those who want to hedge the currency risk, the relatively high interest rates and potential rate cuts from central banks in emerging markets make that an appealing strategy.”