Near-zero yields are entrenched across the developed world. Fine-tuning around the edges of portfolio construction, or holding out in hope of eventual yield normalization is no longer a viable strategy to meet return targets.

Investors searching for more attractive yields are increasingly eyeing emerging market debt, a highly diversified and less-trafficked space with a solid risk-reward proposition. Yet, investing in this diverse terrain generally requires caution and expertise. This is especially true in the wake of the COVID-19 crisis, which has magnified many preexisting strengths and weaknesses across the asset class. Here we look at the dynamics driving the asset class, where we see opportunities, and potential pitfalls to watch out for.

A strong foundation provides resiliency

Strong economic fundamentals may provide a powerful driver for the emerging markets asset class. Most emerging markets entered the pandemic with moderate levels of leverage, manageable inflation, and limited reliance on external creditors. Much of Asia, anchored to China’s impressive recovery, has continued to expand. Other countries, notably Russia and Saudi Arabia, carry little debt relative to GDP, and therefore benefit from solid balance sheets. All remain highly creditworthy.

Underpinning these improved fundamentals is a growing self-sufficiency. For many countries, this includes a shift in the debt composition from external to local, more credible institutions (particularly central banks), the growth of local onshore asset managers, pension funds and insurance companies, and greater exchange rate flexibility.

The result: These strengthened economies may now have the financial flexibility critical to weather a possible prolonged recovery from COVID. For the first time, policymakers in a wide range of developing countries have been able to follow their developed market counterparts, allowing fiscal deficits to widen, easing policy rates, injecting liquidity into their financial systems, and even implementing quantitative easing. Historically, many emerging market countries were not able to use these tools because they weaken currencies, thereby exacerbating foreign currency debt burdens in local currency terms and giving rise to inflation.

For these reasons, we expect compelling loss-adjusted yields (i.e., yield minus defaults) in emerging markets, especially compared to more familiar sources of yield. In fact, our internal analysis indicates that the largest part of the compensation investors earn in emerging markets is for liquidity, complexity and unfamiliarity, not the risk of default. This is consistent with data from the ratings agencies and holds across the ratings quality spectrum.i It is also consistent with academic literature.ii We believe the potential to harvest this “excess over default” premium and compound it over time is powerful for investors looking beyond their home markets.