EMFX and Fixed Income: Where the Opportunities Actually Are

Emerging market debt is one of those things that sounds exotic until you look at the numbers. Then it just sounds obvious.

Chapter 1 of this book is basically making one argument: EM fixed income is too big, too profitable, and too full of alpha opportunities for serious investors to ignore. Let me walk you through it.

The Growth Story Is Insane

Remember the EM crises of the late 1990s? Countries like Russia, Thailand, Argentina were blowing up left and right. The common thread? They had borrowed tons of money in US dollars. When the dollar got strong, that debt crushed them.

So after getting burned, EM countries did something smart. They started building local currency debt markets. Instead of borrowing in dollars and praying the exchange rate held up, they started issuing bonds in their own currencies.

The result? Local currency sovereign debt has grown at a 15% compound annual growth rate since 2003. Compare that to about 7% for USD-denominated debt. Even the 2008 global financial crisis barely made a dent in that growth trajectory.

By end of Q3 2019, EM sovereign local currency debt markets sat at $10.5 trillion. China alone accounts for about $5.1 trillion of that, roughly half the entire market. And China’s share keeps growing. India adds another $1 trillion. These two countries are simply too large for global debt managers to pretend they don’t exist.

Here’s another stat that tells the story: EMFX daily trading volume reached $1.7 trillion per day by 2019. That’s 13% of total global FX volume, up from basically zero in 1995. When you invest in local currency bonds, you have to trade the currency too, so these numbers move together.

External Debt Is Growing Too, But Differently

External (USD-denominated) debt also hit $2.3 trillion by Q3 2019. But the growth engine is different from local markets. Since sovereign issuers shifted toward local currencies, the growth in external debt comes from two places:

First, EM corporates stepped up, especially exporters who are naturally hedged because they earn dollars. Corporate external debt reached around $1.1 trillion.

Second, more countries started issuing. The number of countries in the EMBI sovereign bond index has soared post-crisis, while the local currency index barely added new members. New issuers find it easier to tap external markets first, then eventually build local currency markets later.

The Returns Are Actually Good

This is where it gets interesting. Over the full 2003-2019 period:

• EMBI (external sovereign debt): 7.9% mean return, 5.5% volatility, information ratio of 1.44
• GBI-EM (local currency): 7.0% mean return, 9.5% volatility, information ratio of 0.73
• CEMBI (EM corporates): 6.9% mean return, 4.1% volatility, information ratio of 1.67

Compare those to the US AGG (broad US bonds) at 4.0% mean return with a 1.14 information ratio. The EMBI outperformed the US AGG over the full USD cycle. And the GBI-EM outperformed the non-USD portion of the global government bond index (WGBI ex-USD).

But here’s the key insight about local markets: almost all the volatility comes from FX, not from the rates themselves. If you hedge the currency, local market bonds are actually less volatile than credit indexes. So if you don’t have an edge in predicting currencies, the smart move is to hedge the FX and lever up the rates exposure.

By region, Latin America delivered the highest returns in both local and external markets, and conveniently also has the highest index weight. Asia had the lowest returns but also the lowest volatility. The pattern makes sense when you think about carry: Latam is high carry, Asia is low carry. For cash-constrained investors, Latam deserves the most attention.

You Can’t Fake This With Developed Market Assets

The authors tested whether you could just replicate EM local bond returns using US Treasuries and the Dollar Index (DXY). You can’t. The GBI-EM strongly outperforms this simple replication strategy. EM alpha is real and it’s not just dressed-up DM exposure.

The correlation is high enough that G10 assets work as decent hedges for an EM portfolio. But as a replacement? Not even close.

Where the Alpha Actually Comes From

Here’s where it gets real for fund managers.

Credit funds add real alpha. EMBI-benchmarked funds generated positive excess returns of about 0.63% annually over 2003-2018. How? Mostly by overweighting high-yield components. About 37% of the outperformance is explained by just being overweight the risky stuff. The beta of excess returns to the high-yield subindex averages 10%.

Local funds barely add any alpha. GBI-EM benchmarked funds actually had slightly negative excess returns (-0.14%) over the same period. Higher trading costs, withholding taxes in places like Indonesia and Colombia, and the difficulty of timing FX all eat into returns.

The difference makes sense. In credit, you can generate alpha by picking the right countries and leaning into high yield. In local markets, you need to get FX right, and FX is notoriously hard to predict.

Everyone Is Doing the Same Thing

This is maybe the most interesting finding. The authors ran a principal components analysis on EM credit fund excess returns. The first principal component explains about 90% of the variance. Translation: almost all EM credit funds are running the same strategy. They’re all overweighting high yielders.

That’s fine when it works. And it has worked because EM credit has been in a structural bull market. But it’s obviously a strategy that falls apart when credit sells off. The herding behavior means the whole industry is exposed to the same risk.

Dispersion Tells You Where to Focus

The dispersion of returns across countries (top 10th percentile minus bottom 10th percentile) shows where country selection actually matters:

• EMFX: median dispersion of 6.9% (highest)
• EM credit (EMBI): median dispersion of 6.3%
• EM rates: median dispersion of 4.0% (lowest)

FX and credit are where picking the right countries gets you the biggest payoff. Rates have less dispersion because US Treasuries set the tone for the long end of EM curves. If you’re a cash-constrained investor who can’t lever up rates, focus your country selection energy on FX and credit.

The Sweet Spot

The authors’ conclusion is worth repeating: EM fixed income is in a sweet spot right now. The markets are large enough and liquid enough for big investors to take meaningful positions. But they’re not so liquid that all the alpha has been arbitraged away.

Passive investment is growing in EM, sure. But it’s growing slower than in developed markets because EM indexes are harder and more expensive to replicate. EM ETFs tend to underperform their benchmarks. That’s good news for active managers.

The bad news? Most of the industry is generating alpha the same way: overweight high yield, hope the bull market continues. The authors argue that more systematic approaches can improve on this, and that’s basically what the rest of this book is about.

EM fixed income is too big to ignore, returns are too attractive to pass up, and there’s too much alpha left on the table for anyone who’s willing to be more thoughtful about how they trade it.

Book: Trading Fixed Income and FX in Emerging Markets Authors: Dirk Willer, Ram Bala Chandran, Kenneth Lam Publisher: Wiley Year: 2020 ISBN: 978-1-119-59905-0

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