EM investment grade sovereign hard currency debt in central bank portfolios
Central banks can better balance their reserves objectives with the potential of robust risk-adjusted returns from the asset class.
The framework for managing reserves by central banks has generally focused on achieving three key objectives: capital protection, liquidity and return. Optimizing along these parameters inevitably involves making trade-offs.
Traditionally, capital protection and liquidity have been the two dominant objectives with risk-adjusted returns ranking lower. The era of ultralow interest rates and subdued volatility that prevailed after the Global Financial Crisis prompted reserve managers to broaden their investable universe to generate higher returns and to protect their capital in real terms (see Figure 1). Many diversified away from fixed income into listed equity to take advantage of low volatility and negative correlation with government bonds.
However, we are now entering a new regime that might be marked by higher interest rates, more volatile business cycles and positive stock-bond correlations.
This shift will require a rethink of asset allocation and diversification concepts among central banks. In the new investment regime, fixed income is likely to play a crucial role not only in terms of capital protection, but also as a source of income.
It is an asset class that can strike a balance between the different constraints that central banks are subject to, while also making a significant contribution to protecting their reserves in real terms: emerging market (EM) investment grade sovereign debt in hard currency.
Figure 1: Framework for managing central bank reserves
Figure 1: Framework for managing central bank reserves
Sovereign Wealth Management
Capital Protection
Working capital
Asset appreciation
Saving assets
Macro risk hedging
Hedging assets & strategies
Fixed Income
Money Market Funds
Gov Bonds (Short Duration)
Agency Bonds
Fixed Income
Emerging Market Bonds (Hard / local currency)
IG Corporates
Equity DM and EM
PE, VC, Co-invest.
Fixed Income
Gov Bonds (Long Duration)
Inflation linkers
Gold & Commodities
Real Estate
Hedge Funds
ESG consideration: Green Bonds, Sustainable Equity, Green Alternatives
Benchmark and governance considerations
Asset Class Review 2023
Asset Class Review 2023
2023 has been a rollercoaster for global markets, including fixed income. From a “Goldilocks” scenario in January, markets moved quickly to a “No Landing” narrative in February; expectations for interest rate hikes’ shoot up to 6%. In Spring, the US mid-sized banks’ crisis shook markets and suddenly interest rate cuts were priced in for summer. However, in the following months, fears of a broadening of the financial crisis subsided quickly and economic resilience and persistent inflationary pressure pushed markets back to a higher-for-longer narrative. US 10-Y rates rose to above 5% in October, the highest level since before the Great Financial Crisis.
In the last two months of the year, however, growing evidence of inflation falling towards target, more dovish communication by central bankers and hopes of rates cuts in the first half of 2024 led to a rally in the bond market. As a result, the global government bond market did not suffer a third year of negative returns, something that would have been almost unprecedented in the post-war period.
Emerging market sovereigns bonds also performed well. EM investment grade government bonds delivered a return of 7.1%, almost 2% above advanced economies’ government bonds. EM High yield Sovereigns generated returns above 15%.
Figure 2: Government Bond Market, 2023 returns
Figure 2: Government Bond Market, 2023 returns
Asset Classes | Asset Classes | Return | Return |
|---|---|---|---|
Asset Classes | Advanced Economies Global Government Bonds 1-3 year* | Return | 4.5% |
Asset Classes | Advanced Economies Global Government Bonds* | Return | 5.3% |
Asset Classes | Emerging Economies Sovereign Bonds** | Return | 11.1% |
Asset Classes | Emerging Economies Sovereign Investment Grade Bonds** | Return | 7.1% |
Asset Classes | Emerging Economies Sovereign High-Yield Bonds** | Return | 15.4% |
Asset class outlook
Asset class outlook
The shift from the lower-for-longer regime that prevailed since the early 2010s to higher-for-longer following the COVID crisis has led to a dramatic increase in the expected returns of fixed income assets. Given its traditionally low volatility when compared to listed equity, fixed income assets have become relatively more attractive in risk-adjusted terms. This provides reserve managers with an excellent opportunity to potentially generate adequate returns relative to previous investment regimes.
For instance, a short-duration global government bond portfolio resembling the composition of global FX reserves – largely USD, plus euro, sterling and yen – is expected to generate an average annual return of around 4% in the next five years, according to our estimates. Between 2009-2021, the same portfolio generated a return of less than 1%. A similar portfolio but with long-duration holdings is expected to generate a return of around 5% over the same period; nearly 1% higher than in 2009-21.
Higher returns are also expected for spread assets. An investment grade corporate bond portfolio is expected to generate a return of around 6% over the next five years, 5% higher than in 2020.
Emerging market debt (EMD) in hard currency is also expected to generate robust returns. According to our estimates, in a softish landing scenario this asset class could generate an annual return of nearly 9%. This expected return is higher than listed equity but with a much lower level of volatility.
EMD’s high return expectations also hold up across more pessimistic scenarios. The table below outlines the expected 5-year returns for EM hard currency debt under a number of different economic scenarios. The results show that even in the relatively downbeat recession and stagflation scenarios, nominal 5-year returns are expected to be relatively high when compared with historical returns.
For reserve managers, hard currency EMD could partly replace the return enhancement role played by listed equity with the advantage of lower volatility.
Robust risk-adjusted returns
Robust risk-adjusted returns
Over the past decade, emerging market sovereign debt has approximately doubled in size from around USD 700 billion in the early 2010s to over USD 1.5 trillion at the end of 2023 according to data from Bank of America. Over half of this debt is rated investment-grade.
Through this period, emerging market economies have grown, on average, almost 2 percentage points higher than developed economies (see Figure 4). This growth has not been achieved solely through increased spending. Gross government debt is still under 60% of GDP (gross domestic product), while for advanced economies it has consistently exceeded 100%.
Growth prospects for EM countries such as Mexico, Brazil and Poland are likely to improve, led by a pick-up in near-shoring and friend-shoring activities and in foreign direct investments as businesses adjust their global supply chain strategies. This economic growth without a commensurate increase in debt implies that debt/GDP ratios for hard currency EMD should continue to improve.
Figure 4: EM-DM growth differential
Robust emerging market economic growth also implies a rise in the number of net creditor countries. Including the latest projection of the United Arab Emirates’ international investment position, the total net foreign assets netted of foreign liabilities for investment grade sovereigns with the JP Morgan Globally Diversified Emerging Market Bond Index (EMBI) stands at USD 2.5 trillion.
Yields on investment grade EMD are still at what we consider attractive levels despite spreads gapping tighter especially into year-end 2023.
EM investment-grade sovereigns kick-started the primary market in 2024 and this supply was well absorbed given the backdrop of light investor positioning in the asset class. According to Morgan Stanley estimates, EM hard currency issuance is expected to increase on a year-on-year basis.
EM external debt net issuance is expected to be negative, which should create an upward pressure on existing bond prices. Thus, the asset class appears to be one of the few opportunities in fixed income to invest in growth at a reasonable price.
Balanced economic policies
Balanced economic policies
Over the past 50 years, many countries in Latin America and other emerging markets experienced recurring high inflation coupled with economic and financial crises. Central banks in these countries developed hands-on experience dealing with inflationary regimes as well as financial instability. Certain countries adopted the inflation-targeting approach from developed markets that recognizes the key role of central bank monetary policies in determining the inflation rate.
Controlling inflation has been one of the drivers of rapid economic growth and stability in output and employment in several emerging market economies. To stem inflation, many EM central banks started raising policy rates from as early as 2021, while DM central banks were still grappling with how best to respond. A case in point is the Brazilian Central Bank, which hiked rates at 12 consecutive policy meetings from a low of 2% in March 2021 to 13.75%. It decided to stop hiking only after inflation starting to trend lower.
Such actions have played a large part in elevating the credibility of emerging market sovereigns and the credit ratings not only for the sovereigns but also for the domestic companies that have been on an improving trajectory, as shown below. The inclusion of higher-rated Gulf Cooperation Countries (GCC) has further boosted the upward rating migration trend.
Return of and return on capital
Return of and return on capital
Liquidity and return of capital continue to be the overriding objectives from a reserve management perspective, and these have often been prioritized at the expense of returns. When looking at the returns generated from underlying investments, it is perhaps helpful to look at the Sharpe ratio – i.e., how much excess return you receive for the volatility of holding a riskier asset and is an objective metric for risk-reward.
As shown below, the return profile for emerging market investment grade (IG) debt is significantly above that of sovereign debt issued by the US or other DM sovereigns – and even broad equity indices. While the EM IG Sharpe ratio is comparable to that of US IG, the returns are higher by 0.64% on an annualized basis. Investors with longer investment horizons, such as central banks, who can ride through periodic bouts of volatility, should be well positioned to harvest this premium.
Figure 5: Sharpe ratios
Figure 5: Sharpe ratios
Asset Class | Asset Class | Return | Return | Risk | Risk | Sharpe | Sharpe |
|---|---|---|---|---|---|---|---|
Asset Class | EMBI GD IG | Return | 5.10% | Risk | 7.30% | Sharpe | 0.70 |
Asset Class | US IG | Return | 4.46% | Risk | 6.13% | Sharpe | 0.73 |
Asset Class | US Treasuries | Return | 2.82% | Risk | 4.49% | Sharpe | 0.63 |
Asset Class | Global Treasuries | Return | 2.73% | Risk | 6.94% | Sharpe | 0.39 |
Asset Class | S&P-500 | Return | 11.36% | Risk | 17.35% | Sharpe | 0.65 |
Asset Class | MSCI World | Return | 7.96% | Risk | 17.20% | Sharpe | 0.46 |
Expanding buyer base
Expanding buyer base
Sovereign debt indices, unlike equity indices, are constrained at the country level, and 10% is the maximum permitted for a single country in the JP Morgan Emerging Market – Global Diversified Index. As of end-December 2023, Mexico has the largest weight in the index at 5%, while Saudi Arabia is at 4.8%.
Historically, emerging market debt tended to be held by overseas portfolio investors. However, in certain regions such as the Middle East, local institutions are now part of the buyer base. They are effectively buying dollar-denominated debt issued by their home/sovereign country – a safe haven asset for them. This has had positive implications for bond spreads and volatility.
Finally, asset allocators with longer-term investment horizons such as global insurance companies, pension funds and endowments are starting to recognize the benefits and raising their allocations to the investment grade segment of emerging market hard currency debt.
Figure 6: Improving credit ratings
Spreads and liquidity
Spreads and liquidity
Bank failures, currency sell-offs and systemic corporate defaults have plagued emerging market countries in the past, causing their bonds to trade at a discount. However, spreads on EM IG sovereigns now move more in line with US investment grade corporates (see Figure 7).
In March 2023, when US regional banks such as SVB Group failed because of a mismatch in assets and liabilities, EM IG sovereigns held up relatively well. The percentage spread widening from end-February to mid-March 2023 for US IG was 31%, almost double EM IG’s 16%.
Since January 2021, the share of single-A and above ratings has risen in both EMBI IG and US IG indices. However, the increase is much greater for EMBI IG. Single-A and higher rated countries now comprise 47% of the index, versus 39% in January 2021. For US IG the figures are 52% versus 49%. Spread compression to US IG has been achieved along with an increase in the quality of the underlying assets.
The flurry of Issuance In hard-currency issuance since the start of 2024 shows up in the relative underperformance of EM investment grade bonds relative to US IG. The drivers behind this include valuations due to moves in US treasuries, bond issuance relative to muted inflows and geopolitics. That differential is at one of the widest points since early-2022 and given it does not last for long, this is an opportune time to revisit allocations to the asset class.
Prior to the Global Financial Crisis, bonds were predominantly traded by dealers and sell-side financial institutions. After Lehman Brothers filed for bankruptcy, banks had limited confidence in the ability of trading counterparties to honor their commitments. Given the nature of the trading ecosystem back then, it is perhaps unsurprising that liquidity in the bond markets dried up during that tumultuous period.
Post-crisis, regulators raised bank capital requirements and adopted other measures that reduced broker-dealers’ ability and willingness to make markets in bonds. Electronic trading platforms stepped into this liquidity void and firms such as MarketAxess and TradeWeb now offer a diversified pool of liquidity, significant cost savings to institutional investors and greater trading efficiency. This is evident in the jump in market share for US high-grade corporate bond trading for MarketAxess from 9.4% in 2007 to over 21% in recent years.
Enhanced Multilateral Backstop
Enhanced Multilateral Backstop
Countries are receiving unprecedented liquidity support from multilateral agencies and lenders. Through the Resilience and Sustainability Trust established in 2023, the IMF is playing an increasingly important role in helping countries with limited room in their budget to address long-term challenges. The IMF Board approved a proposal to increase members’ quotas proportionally by 50%. The quotas, which take effect in 2024, will increase by USD 314 billion to a total of USD 941 billion. The proposal will impact the interest paid to the IMF as surcharges depend on the amount and duration that IMF credit has been outstanding.
The World Bank has proposed new steps to significantly boost its lending capacity. Specifically, it is increasing the guarantees provided by World Bank shareholders, raising hybrid capital from shareholder countries, and lifting the current roadblocks that hinder callable capital. Further, the World Bank is also fundraising for a new International Development Association (IDA) Crisis Facility which will strengthen its ability to help the neediest countries in challenging times.
Therefore, even in a higher for longer environment emerging market sovereigns will be able to refinance at attractive rates. Lack of access to capital markets, a key vulnerability marker, is unlikely to be an issue in 2024.
Summary
Summary
The investment grade emerging market debt market reflects a healthy picture of strongly growing economies with relatively low levels of indebtedness and often combined with net creditor status. In dealing with inflationary regimes, EM countries were the first to raise interest rates and are now easing rates ahead of DM countries, which should be positive for EM debt yields.
The IMF stands ready in its role as the lender of last resort with funds that can likely be used for refinancing of sovereign debt.
EM investment grade hard currency sovereign debt appears attractive on a risk/return basis when compared to other asset classes over different economic scenarios. We believe it should play an important role in central bank asset allocation considerations. Given the current uncertain backdrop, hard currency EMD can help strike the right balance between the objectives and constraints of central banks and help protect capital in real terms.
Make an inquiry
Fill in an inquiry form and leave your details – we’ll be back in touch.
Introducing our leadership team
Meet the members of the team responsible for UBS Asset Management’s strategic direction.
