Making the (Credit) Grade in Emerging Markets (Koesterich)

October 21, 2011

3 minute read

by Russ Koesterich, Portfolio Manager, iShares

In recent months, I’ve pointed out some of the opportunities in emerging market equities. There is an equally compelling case to be made for emerging market debt.

Emerging market debt is a way to diversify your emerging market exposure, especially if you are worried about a slowing global economy. Even more, when it comes to your fixed-income allocation in general, there’s a long-term reason to consider emerging market debt: Credit quality.

While emerging markets are not without their share of macroeconomic problems, they are not experiencing the same sovereign debt problems as their developed market neighbors. In fact, the world’s sovereign debt problems are centered in developed markets such as Europe, the United States and Japan. I’ve already mentioned this as a fact supporting emerging market equities. It’s even more supportive of emerging market fixed income.

As emerging markets are not nearly as indebted and ridden with fiscal problems as developed markets, emerging market debt could arguably provide lower credit risk. This is especially true if you believe the developed world’s fiscal problems are only likely to get worse over the long term.

Last year, according to an October 2010 J.P. Morgan research report, credit agency upgrades of emerging market ratings far outpaced downgrades, while the opposite was true for developed markets. With agency downgrades of developed markets in the news daily now, the trend is likely continuing this year.

The BlackRock Investment Institute’s Sovereign Risk Index, meanwhile, provides another measure of a country’s sovereign risk. According to the Institute’s October risk index data, many emerging market countries are ranked higher (i.e. less risky) than their developed market counterparts (see the full ranking here). South Korea, Chile, Thailand, Malaysia, China and Russia, for instance, all have higher index scores than a number of European countries including the United Kingdom, France, Italy, Ireland, Portugal and Greece.

But while there’s a case for emerging market debt, I’m not advocating that investors abandon Treasuries in favor of Brazilian debt. There are several caveats emerging market debt investors need to keep in mind. First, these are generally new debt markets with corporate debt and corporate governance issues. In addition, widespread risk aversion would hurt emerging market debt. In light of these risks, investors — particularly risk averse ones — should be cautious, and keep their allocation to this asset class modest.

With that caveat, emerging market debt may be worth considering in the longer term if you’re worried about a further deterioration of credit quality in the developed world (possible iShares solution: LEMB and EMB).

Disclosure: Author is long EMB

Diversification may not protect against market risk.

Bonds and bond funds will decrease in value as interest rates rise. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. Bond funds may be subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments.