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The global financial crisis of 2008 was unique not only for its severity, but also for the fact it was the first credit crisis in recent history whose origin was the financial system of the mature economies. The bursting of the U.S. housing bubble and the damage that followed has upended many long-held views about markets and risk. In the past it has usually been the emerging markets that were plagued by financial crises and prone to defaults. Now, it is the state of public finances in Europe, Japan and even the U.S. that is increasingly a source of concern for investors.

Not long ago the emerging markets (EM) were considered too risky for many investors. But the strength and resilience of emerging market economies (EMEs) has increasingly drawn the attention of investors to their fixed income, which has been one of the best performing segments of the global bond market for the past decade. In the process, emerging market debt (EMD) has been transformed from a niche sector to an important component of the global debt market.

Yet, for all its growing prominence and appeal, many individual investors have little or no exposure to these securities and the asset class remains poorly understood.

In this paper we examine the long-term investment case for EMD, its different types, their sources of risks and returns, and the strategic role of these assets in a traditional portfolio.

What is Emerging Market debt?While there is no standard definition of an “emerging” market, the term generally refers to countries whose economies are developing rapidly and are in the process of transitioning from agrarian to industrialized societies. They include many of the countries of Africa, Latin America, Eastern Europe, the Middle East and Asia, excluding Japan. This means the EM universe contains a diverse group of countries in different stages of the development cycle—some with fairly established fixed income markets such as China, India and Mexico, and others with nascent bond markets such as Pakistan, Iraq and Vietnam.

Until the late 1990s, emerging market debt was a fairly small asset class consisting primarily of government bonds denominated in U.S. dollars. Buoyed by rapid economic

KEY IMPLICATIONSThe long-term investment case for emerging market debt (EMD) is driven by a number of key developments in the emerging economies that contrast sharply with conditions in the developed markets: strong growth prospects, comparatively low debt burdens and favorable demographics. The improving fundamentals are helping to reduce the risks associated with EMD.

At a time when yields on traditional fixed income instruments such as U.S. Treasuries and investment grade corporate bonds are near their historic lows, EMD offers the potential for high yields and strong cash flows, and total returns.

Types of EMDToday the EMD asset class consists of three key categories: (1) U.S. dollar-denominated sovereign debt, (2) local-currency sovereign debt and (3) U.S. dollar-denominated corporate debt.

Each subsector possesses its own distinctive attributes that can bring different benefits and risks to a portfolio. U.S. dollar-denominated debt includes a spread component over U.S. government bonds of similar maturity, while local currency debt is substantially influenced by foreign exchange (FX) fluctuations and local yield curves.

EMD as a portfolio assetEMD has historically exhibited low correlation to traditional fixed income and moderate correlation to equities. EMD can be an effective diversifier, with the addition of both dollar and local-currency EM debt to a traditional 60/40 portfolio improving the risk-adjusted return potential.

Gaining exposure to EMDJust as the EMD sector has grown in size over the past decade, so have the vehicles available to gain exposure to it. Investors can now choose from a breadth of products, both passive and active, ranging from Exchange Traded Funds (ETFs), Closed End Funds (CEFs) and mutual funds to hedge funds and Separately Managed Accounts (SMAs).

Yago Gonzalez Director, Portfolio Construction and Management

APRIL 2015Examining Emerging Market Debt

Examining Emerging Market Debt | 2

development in the underlying countries, the sector has expanded at an annualized rate of approximately 15% since 2000 and as of the end of 2013 it has a market value of $14.5 trillion. EMD now makes up approximately 13% of the world’s fixed income market and has grown to include a wide array of sovereign and corporate bonds denominated in both local and major foreign currencies as well as a range of supporting credit derivative instruments.1 In our opinion, as the sector has expanded, investing in EMD has become less speculative and tactical and more strategic in nature.

The EMD value propositionOne of the legacies of the financial crisis has been the scarcity of growth in developed markets. This in turn has led to a lack of income opportunities in these countries. For U.S. investors, yields offered by traditional fixed income—Treasuries and investment grade (IG) corporate bonds—have fallen to historic lows. That has created a quandary for many investors whose returns expectations are reflective of more conventional interest rate environments.2 Adding to the problem is the fact that a considerable proportion of the same investor base is aging and increasingly requires more

cash flows from their investments to cover living expenses as they retire.

On the flip side, an uptick in growth and inflation in the U.S. also poses significant risks for holders of Treasuries and high-grade corporates. That’s because bond prices are more sensitive to changes in interest rates when yields are low: a given rise in interest rates causes a larger decline in prices.3 It could mean that traditional debt, generally very reliable, becomes a growing source of portfolio risk.

Amid these circumstances, EMD can present investors with an appealing alternative to traditional fixed income. EMD has historically been a high-yielding and strong income-generating asset due to higher levels of credit, liquidity and, in some cases, currency risk. As we shall see some of these risks have decreased in recent years. Yet, these assets have the potential to offer better yields than traditional forms of debt with comparatively shorter duration. Translated, that means—all else equal—EMD can provide investors higher interest rates at lower interest rate risks.

At its core, the increasingly attractive yield-to-risk profile of EMD is based on the stronger economic outlook of the EMEs relative to the developed markets. While the latter continue to be hobbled by weak demand and high indebtedness, most EMEs are growing at or above the level of developed markets. As a group, the EMEs are now responsible for nearly three-quarters of global growth—up from one-third just a decade ago. GDP growth rates for EMEs are expected to be nearly double those of the advanced economies over the next five years (see Exhibit 2 on the next page). Underlying this remarkable progress has been a set of improving policy fundamentals.

Following a period of growing pains in the 1980s and 1990s many EMEs undertook a series of significant reforms in the 2000s that strengthened their economic foundation. EMEs now run disciplined fiscal and monetary policies, hold ample foreign exchange reserves and carry current account surpluses (by which the value of their exports exceeds imports). These developments have reduced the risks associated with unexpected currency fluctuations and capital flight that made EMD such a volatile investment in the past. They also allowed EMEs to reduce their dependency on debt.

Numerous studies have highlighted the detrimental effects of elevated debt levels on economic growth. Reinhart and Rogoff (2010), for example, find that countries with a debt-to-Gross

1 Brauer, J. (2014, July 10). Size and structure of Global Emerging Markets debt. BofA-ML Global Research.2 Current bond yields are generally a good indicator of future returns. That’s because it is the reinvestment and compounding of coupons that is the biggest source of bond returns

over time. Compounding is less effective in a low interest environment than a high one.3 For bond math examples see the Mauro, M. & Richardson, E. (2012). Get shorter, but not short. BofA-ML Global Research.

EM Sovereign

EM LocalEM Corp

U.S. HY

U.S. IG Corp

U.S. Treasuries

DM Sovereign(xU.S.)

Munis

0%

1%

2%

3%

4%

5%

6%

7%

3 4 5 6 7 98

Yiel

ds

Effective Duration

Exhibit 1: Yields across the fixed income spectrum (Dec, 31 2014)

Source: BofA-ML Global Research, Investment Management & Guidance (IMG). EM sovereign debt (USD), EM sovereign debt (Lcl FX), EM corporate debt (USD), U.S. Treasuries, DM Sovereign (xUS), U.S. investment grade (IG) debt, U.S. high-yield debt and Municipals are represented by the BofA-ML Global Sovereign Market Plus, BofA-ML Local Debt Markets Plus, BofA-ML Emerging Markets Corporate Plus, BofA-ML Treasury/Agency Master, BofA-ML Global Govt. Bond II xUS, BofA-ML US Corp Master, BofA-ML US High Yield Master II and BofA-ML US Municipal Securities Index. See index definitions at the end of the Whitepaper. The investments illustrated have varying degrees of risk. The risk of loss and potential reward of return have a direct relationship for investments: in-general, the higher the risk to the principal invested, the greater the potential return. Conversely, investments that have lower risks typically offer smaller returns. U.S. treasury bonds are guaranteed by the U.S. government and, if held to maturity, offer a fixed-rate of return and guaranteed principal value. U.S. treasury bonds are issued and guaranteed as to the timely payment of principal and interest.


Domestic Product (GDP) ratio over 90% display significantly lower growth than countries with lower debt burdens. At the end of 2013 the average debt-to-GDP ratios of developed countries was 116%, while the corresponding levels for EMEs was just 42% of GDP (see Exhibit 3).

Finally, let’s not forget the demographics equation (hinted at earlier). The emerging markets account for more than 70% of the world’s population, less than 5% of whom is over 65 years old. The expanding working population in these countries is expected to help increase the domestic consumer base in the EMEs, aiding growth. By comparison, most advanced countries are projected to see significant declines in the working-age populations over the next two decades, straining resources and creating serious obstacles to growth.

Taken together, in our opinion, these factors make the long-term secular case for EMD very compelling—in terms of not just yields

but also potentially attractive total returns as we believe the risks associated with emerging markets will continue to improve.

Which type of EMD to invest in?For investors confident in the emerging market story as presented above, the question becomes: which type of EMD makes most sense? Investors today have three main choices: (1) U.S. dollar-denominated government (sovereign) debt, (2) local-currency sovereign debt and (3) U.S. dollar-denominated corporate debt. Each subsector possesses its own distinctive attributes that can bring different benefits and risks to a portfolio. In the next few sections we compare these separate markets.

As a first step, we need to understand what investors are actually buying in each case. To better appreciate and compare the different categories of EMD, we use relevant BofA-ML indexes as proxies for the underlying asset class. These include the Global Emerging Market Sovereign Plus (“GEMSP”), Local Debt Markets Plus (“LDMP”) and the Emerging Markets Corporate Plus (“EMCP”). All of our figures and descriptions of EMD refer to these indexes.4

Characteristics of the different EMD markets The market for U.S. dollar-denominated debt is the oldest and broadest of the three. It includes the direct sovereign and quasi-sovereign debt of 66 countries. The dollar sovereign bond market offers a diverse collection of issuers from large, established sovereign credits, such as Brazil and Mexico, to newer and riskier entrants to the bond markets such as Rwanda and Iraq. In terms of credit profile more than 70% of the outstanding debt is now rated as investment grade, up from just 23% a decade earlier.

The local-currency sovereign bond market, by comparison, has fewer individual country exposures. Currently there are only 17 countries making up the LDMP Index. However, in terms of size, the local-currency debt market is nearly three times as large. This is understandable, as countries that are able to borrow in their own currency are also usually the ones that are farthest along the development curve and tend to have the biggest fixed income markets. Not surprisingly, local-currency debt is generally of higher credit quality than dollar-denominated bonds; the vast majority of the debt—approximately 95%—is rated as investment grade. Thriving domestic bond markets, in turn, strengthen local economies by allowing governments to borrow at lower costs and at longer maturities.5

Emerging Economies Developed Economies

Annu

al G

DP G

rowt

h at

PPP

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

2000 2002 2004 2006 2008 2010 2012 2014E 2016E

Exhibit 2: EMEs growing faster than developed economies

Source: International Monetary Fund (IMF), IMG

0%

50%

100%

150%

200%

250%

Japa

n Gr

eece

Po

rtug

al

Irela

nd

U.S.

A Be

lgiu

m

Fran

ce

Cana

da

U.K.

Ge

rman

y Sp

ain

Egyp

t In

dia

Braz

il Ar

gent

ina

Mex

ico

Thai

land

Tu

rkey

So

uth

Afric

a Ch

ina

Indo

nesi

a Ni

geria

Ru

ssia

Developed Economies Emerging Economies

Exhibit 3: Public debt outstanding by country (2013)

Source: IMF, IMG

4 All data as of December 2014 unless otherwise specifically noted. A complete definition of each of these indexes can be found at the back of this report.5 They also help to reduce the currency mismatch associated with their liabilities that have contributed to financial crises in the past.


One outcome of large EMEs increasingly raising capital in local markets is that it has opened up the foreign currency borrowing arena to their corporations. The U.S. dollar corporate bond market is the fastest growing segment of the EMD space. It offers exposure to corporations and agencies in 53 different countries, covering more than 1,500 corporate issues across numerous industry sectors. Approximately 75% of all securities are rated as investment grade.

Difference in composition among EMD marketsThe above descriptions reveal some basic differences between EMD markets. For example, dollar bond markets provide investors a broader range of credits to choose from, but the local-currency bond market offers higher creditworthiness.

Further dissimilarities are evident from Exhibit 4, which provides a breakdown of the regional exposures of the different markets. We can see that the local-currency and dollar corporate debt markets offer investors greater exposure to Asia, while the dollar sovereign bond market provides investors more access to Emerging Europe and Latin America. On the other hand, the dollar debt markets imply greater exposure to commodities (based on the individual weightings of commodity dependent countries in the GEMSP and LDMP indexes).

Such differences can have significant investment implications. For instance, they suggest returns to dollar-denominated bonds are much more closely tied to the swings in the commodity cycle, while local-currency bond markets offer better access to Asian economies. Alternatively, the corporate bond markets allow investors a more granular way to play secular themes by focusing on specific industries.

Drivers of returns: Dollar vs. local debtWhile disparities in breadth, credit and geographical composition provide investors with reasons for preferring one type of EMD over another, perhaps the most important difference among these markets stem from their sources of risk and returns. In this regard, the biggest divide lies between dollar-denominated debt and local-currency debt.

U.S. dollar bondsU.S. dollar-denominated debt is really a “spread” product. As in the case of corporate bonds issued by U.S. companies, the potential returns from EM dollar bonds are considered in relation to their spread over comparable default-free U.S. Treasuries as compensation for the additional risk associated with these securities. This yield spread is influenced, among other things, by (1) the default risk and (2) Treasury yields.

Typically, the default probability is related to a country’s macroeconomic fundamentals, such as real GDP growth, fiscal conditions and the existing public debt. All else equal, the greater the creditworthiness of the sovereign issuing the debt, the narrower the yield spread; and vice versa. Corporate dollar bonds have additional credit risks associated with the balance sheet of the issuing company.

Positive macro developments among the EMEs since the turn of the century, coupled with the deterioration of the same within the developed countries, has helped bring down overall yields and increase the value of dollar bonds, as shown in Exhibit 5 (on the next page). These changes have spurred improving conditions at the micro level as well. Ratings on EM corporate debt have steadily improved, supported by growing return on equity (ROE) and decreasing leverage.6 Continued divergence in the credit profiles of the emerging and developed countries should help drive returns for dollar-denominated bonds over time.

Shorter-term, movements in the benchmark U.S. Treasury yields can influence returns on EM debt even more. All else equal, the lower the yields on U.S. Treasuries, the lower the yield on EM dollar bonds; and vice versa. Referring back to Exhibit 5 (see next page), we can see that Treasuries contributed to declining EM bond yields in the 2009-2012 period; but the subsequent increase in Treasury yields was detrimental to EM dollar bond returns.

6 Valluri, A. & Christie, A. (2011). Strategic Emerging. JP Morgan Asset Management.

0% 5% 10% 15% 20% 25% 30% 35% 45% 40% 50%

Africa & ME

Asia

EM Europe

LatAm

EM Corporates EM Local Debt EM Sovereign Debt

Exhibit 4: Regional distribution of EMD indexes

Source: BofA-ML Global Research, IMG. Data as of December 31, 2013.


Local currency sovereign bondsBy contrast, returns on local-currency debt are principally influenced by two different sources: (1) duration, or the sensitivity of bond prices to changes in local interest rates, and (2) currency volatility.

That’s not to say default risk does not impact yields—it does. However, sovereigns that are able to issue debt in local currency generally have stronger fundamentals than countries that borrow primarily in foreign currency. As noted earlier, the LDMP index is solidly investment grade. That means creditworthiness is comparatively less of a factor in determining yields of local-currency debt. Rather, as is the case for debt issued by developed market sovereigns and companies, local interest rates help drive yields.

Exhibit 6 deconstructs the returns on the local-currency sovereign bonds into its two main components. It shows duration (price appreciation and coupon) has been a source of solid, reliable returns. This is to be expected. A crucial factor shaping the direction of interest rates is inflation. Higher inflation is detrimental to bond prices. As shown in Exhibit 7, many EM countries have made immense strides in taming inflation over the past two decades. The consensus is for this trend to continue, which should be supportive of future duration returns.

The currency component, however, is a much more volatile source of returns. EM currency appreciation boosts local debt returns, while depreciation detracts from it. Looking back at Exhibit 6, we can see that foreign exchange (FX) was a positive contributor to local-currency bond returns between 2006 and mid-2008 and again from 2009 to 2011. However, FX weakness drove bond

losses in the second half of 2008 and has dampened returns since 2012.

Currency prices are impacted by many factors. Fundamentally, values are influenced by inflationary expectations, monetary policies, balance of trade and other similar variables that speak to the competitiveness and productivity of one economy versus another. This means that if EMEs continue to grow and experience more rapid productivity growth than the developed markets their currencies should appreciate over time. That said, a country’s FX can frequently deviate from what its longer-term fundamentals suggest. A prime example was the abrupt reversal of inflows during the 2008 financial crisis, propelled by an unwinding of risk and rush to “safe haven” currencies such as the U.S. dollar, euro and yen. The result was a considerable weakening of many EM currencies.

Still, the episode did provide a silver lining for investors worried about the volatility of EM FX. In the past, such a capital flight

EM Sovereign (USD) U.S. Treasuries SpreadSp

read

s (b

p)

Bond

Yie

lds

0 100 200 300 400 500 600 700 800 900 1,000

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2001

2002

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2010

2011

2012

2013

2013

Exhibit 5: EM sovereign (USD) yields, spread (2000-2014)

Source: BofA-ML Global Research, IMG. Past performance is not a guarantee of future results.

Duration (Price+Coupon) Currency Total Return

80 90

100 110 120 130 140 150

170

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06

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Jan-

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Jan-

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Exhibit 6: Breakdown of EM local debt returns (2006-2014)

Source: BofA-ML Global Research, IMG. Past performance is not a guarantee of future results.

0%

10%

20%

30%

40%

50%

1995 1997 1999 2001 2003 2005 2007 2009 2013 2011

Exhibit 7: Figure 5: % of EMEs with double-digit inflation (1995-2014)

Source: IMF, IMG.


might have precipitated a full-blown currency crisis in most EMEs. With many EMEs making the transition from a fixed to a more flexible (and in some cases fully-floating) exchange rate system and holding sufficient FX reserves, the emerging markets appear to be better positioned to withstand such external shocks.

Liquidity and other risk factorsCredit, interest rate and currency risks are not the only concerns for EMD investors. Other factors, such as liquidity—the ability to buy or sell assets without influencing price—and investor attitudes toward risk, including political risks, play an important role in determining bond yields and returns.7 Past research has generally found that dollar bonds tend to be relatively more vulnerable to these issues than their local-currency counterparts. There are several reasons for this is.

One is the much larger market capitalization of local bond markets ($1.3 trillion) compared to the dollar bond markets ($547 billion for USD sovereign debt and $1.1 trillion for USD corporate debt)—though capital controls and more restrictive tax policies on local-currency debt in some key emerging economies serve to hamper some of this incremental liquidity. In addition to size, local bond markets are able to offer investors a greater variety of debt instruments and hedging tools than their dollar bond counterparts; investors in EM local bonds are likely to have access to inflation-linked, currency-linked bonds and derivatives and local money market instruments. Finally, domestic factors, rather than global ones, typically have a bigger impact on local-currency bond yields, potentially allowing for greater portfolio diversification.

To summarize, key differences exist among the different emerging market bonds. U.S. dollar-denominated bonds are spread products,

with a credit risk component and a treasury yield (U.S. interest rate risk) element. Local-currency bonds, by contrast, carry local interest rate and currency risks. These differences can lead to very different return paths. For example, a robust global economy tends to favor local-currency debt (helped by EM currency appreciation and higher Treasury yields), while a weakened one is more supportive of USD-denominated debt (driven by EM FX weakness and depressed Treasury yields). Table 1 highlights the main features of each.

Performance of Emerging Market debtIn recent years all three categories of emerging market debt have generated strong returns. Table 2 (on the next page) shows the performance of the different sectors of the bond and equity markets since 2006—a period for which returns on all types of EMD are available. While recognizing that no one historical period can sufficiently reflect an asset’s performance over different market cycles, the past nine years may in fact provide a fair representation of how different bond sectors behave as it covers the run-up to the peak of a historic bull market, a near-collapse of the global financial system and its subsequent ongoing recovery.

We can see that over this period EMD has outperformed both U.S. and global investment grade bond sectors and performed in line with U.S. and EM equities. The dollar-denominated EM sovereign bonds performed the best over the 2006-2014 period, followed by EM Corporate debt and local-currency debt. Only U.S. high-yield debt and U.S. Equities had higher returns.

On the risk front, not surprisingly, emerging market debt has been more volatile than developed market bonds. Local-currency EM sovereign debt exhibited the highest volatility, with an annualized

Table 1: Comparison of the main EMD sectors*

Source: BofA-ML Global Research, IMG. *Data as of December 31, 2014. Refer to the back for the definition of Effective Yield.

GEMSP EMCP LDMP

Market Size (US$ Millions) 547 1111 1301

# of Issues 358 1637 400

# of Countries 66 53 17

% Investment Grade 71% 75% 95%

FX Denomination U.S Dollar, Euro U.S. Dollar Multiple local currencies

Key Risk Factors Sovereign Credit, U.S. interest rateSovereign credit, corporate credit, U.S.

interest ratesLocal interest rates, currency,

sovereign credit

Effective Yield (%) 5.28% 5.77% 5.92%

Average Duration (years) 6.97 5.10 5.31

7 Both U.S. dollar bonds and local currency bonds have a “market” risk premium to compensate investors for these additional risks.


standard deviation of 10.5%. Dollar-denominated EM government and corporate debt had slightly lower volatilities of 9.8% and 9.3%, respectively. By comparison, U.S. high-yield debt experienced volatility of 10.9%. Significantly, Dollar denominated EM Sovereign Debt and EM Corporate debt indexes displayed higher risk-adjusted returns (Sharpe ratios) than equities. Nevertheless, all three categories of EMD did experience a sharp downturn during the 2008 credit crisis, suffering drawdowns of 20% or more.

Just as interesting and important is the behavior of the different types of EMD before and after the crisis. As noted in the previous sections and evident from Exhibit 8, returns from dollar and local bonds can differ materially from one period to the next.

In the build-up to and during the crisis, local debt outperformed dollar debt. The opposite has been the case during the

subsequent recovery.

Correlations with other assetsReturns are clearly an important factor in considering whether to invest in emerging market debt. Another consideration is the potential diversification benefits of these securities in a traditional portfolio. Table 3 shows the correlations of EMD with mainstream asset classes. EMD has little correlation to developed market government bonds. For fixed income portfolios heavily exposed to the sovereign debt of the U.S., Europe and Japan, both dollar and local EM bonds can be potentially effective diversifiers.

When it comes to corporate credit, the diversification benefits diverge somewhat. Local-currency EM bonds exhibit moderate correlation to investment grade and high-yield corporate bonds, while dollar bonds have shown fairly high correlations. Investors have traditionally sought to enhance portfolio yield with exposure to corporate fixed income, especially high-yield debt. EMD can be a potential substitute for such corporate credit risk. Local-currency bonds, in particular, may offer comparable yields with potentially less credit risk and return volatility.

With regard to equities, the relative movements of local-currency and dollar debt is just the opposite. Dollar bonds have shown moderate correlation with U.S. stocks, while local bonds exhibited comparatively higher co-movements.

What the above performance and correlation history reveals is that while EMD can be a source of significant risk on its own, these securities can help lower the overall volatility of a diversified portfolio. For example, based on historical returns, hypothetically

Table 2: Asset class performances (2006-2014)

Source: MPI, IMG. EM sovereign debt (USD), EM sovereign debt (Lcl FX), EM corporate debt (USD), U.S. Treasuries, Developed Non-US Sovereign, U.S. Investment grade (IG) debt, U.S. high-yield debt, U.S. equities and EM equities are represented by the BofA-ML Global Sovereign Market Plus, BofA-ML Local Debt Markets Plus, BofA-ML Emerging Markets Corporate Plus, BofA-ML Treasury/Agency Master, BofA-ML Global Govt. Bond II xUS, BofA-ML US Corp Master, BofA-ML US High Yield Master II, S&P 500 TR Index and MSCI EM Index, respectively. Past performance is not a guarantee of future results.

Returns VolatilitySharpe Ratio

Max. Drawdown

(DD)

EM Sovereign Debt (USD) 7.7% 9.8% 0.66 -22.9%

EM Sovereign Debt (Lcl FX) 5.3% 10.5% 0.42 -20.0%

EM Corporates (USD) 6.5% 9.3% 0.58 -25.6%

U.S. Treasuries 4.6% 4.3% 0.76 -4.5%

Developed Non-US Svgn 4.0% 2.7% 0.91 -3.3%

U.S IG Corp Debt 5.9% 6.0% 0.75 -16.1%

U.S. High-Yield Debt 8.2% 10.9% 0.65 -33.2%

U.S. Equities 8.0% 15.3% 0.49 -50.9%

EM Equities 6.2% 24.2% 0.32 -61.4%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

2006 2007 2008 2009 2010 2011 2014 2013 2012

EM Corp EM Lcl Debt EM US$ Debt

Exhibit 8: Performance of different categories of EMD (2006-2014)

Source: BofA-ML Global Research, IMG.Past performance is not a guarantee of future results.

Table 3: EMD correlations to other assets (2006-2014)

Source: MPI, IMG.

EM Sovereign USD Bonds

EM Sovereign Local FX Bonds

EM USD Corporate

Bonds

Developed Non-US Svgn 0.17 0.06 0.07

U.S. Treasuries 0.19 0.08 0.09

U.S IG Corp Debt 0.78 0.55 0.83

U.S. High-Yield Debt 0.77 0.63 0.83

U.S. Equities 0.62 0.67 0.59

EM Equities 0.74 0.81 0.70

EM Sovereign Debt (USD) 1.00 0.82 0.92

EM Sovereign Debt (Lcl FX) 0.82 1.00 0.66


including a 10% allocation to dollar EM sovereign bonds in a portfolio consisting of 60% stocks and 40% bonds can reduce expected portfolio risk by 20 basis points. Table 4 displays the impact of allocating different types of EMD to a 60/40 portfolio. (Note: our assigned weightings are purely for illustrative purposes; the optimal EMD allocation will vary for each investor based on his or her goals, needs and existing portfolio risk.)

Accessing Emerging Market debtWe have covered many aspects of emerging market debt— the different types, drivers of returns, benefits in a portfolio, etc. For investors another pressing issue is how actually to invest in these securities. Along with the structural transformations in the EMD sector over the past 15 years, the vehicles available to invest in the space, both passive and active, have also changed dramatically. Investors can choose between exchange-traded funds (ETFs), closed-end funds (CEFs), mutual funds, separately managed accounts (SMAs) and hedge funds (HFs) as well as hybrids of these different structures. While the diversity of vehicles provides tremendous flexibility to investors, the choice of investment vehicle has also become more complicated.

Two important factors to consider when choosing a vehicle are the liquidity and operational cost of the subsector targeted. For instance, the liquidity for a strategy that invests in corporate debt is lower than that for a sovereign strategy. The lower the liquidity, the larger the pool of assets needed to manage the strategy efficiently. Consider also that the operating cost to the manager of investing in corporate debt may be higher than that of doing so in dollar-denominated sovereign bonds. Because of these two factors, most asset managers don’t offer EMD SMAs below the

$50MM threshold. Those that do offer below that threshhold generally offer strategies focused on dollar-denominated sovereign bonds. Even then we would suggest caution as it may be difficult to diversify the portfolio appropriately to mitigate systematic risk.

In the past years investors have also begun to turn to hedge funds to access the sector. While global macro funds have been involved in the sovereign debt markets for some time as part of a broader mandate that includes not just fixed income, but also currencies, commodities and equities, some managers had focused on EM equities. But funds are now progressively looking to the local and corporate debt markets as they grow in sophistication. A draw of HFs is their agility and ability to utilize a wider range of investment techniques, including short selling, derivatives and leverage to unlock value and lower volatility. However, these vehicles usually have large minimums and very high performance fees (typically, 2% of assets under management and 20% of profits). Additionally, HFs can have initial lock-up periods that can extend for a year or more and may only offer investors quarterly redemptions.

CEFs, ETFs and mutual funds offer participation in larger pools of assets at lower minimums and with greater liquidity. Of these, mutual funds offer the most subsector variety although ETFs are catching up fast. EMD-focused CEFs have recently seen a resurgence with the rise in demand for yield, but dedicated alternatives remain relatively limited and these vehicles may be better suited for long-term investors. That leaves us with two main alternatives, ETFs and mutual funds.

The ETF space has grown considerably over the past few years. These passive vehicles offer a convenient and efficient way for investors to gain exposure to the different types of EMD. However, out of the 16 ETFs that we would categorize as broad, only eight have a track record longer than three years. Moreover, assets are concentrated in the three ETFs with the longer track records, which invest mainly in sovereign markets. Although there are vehicles that offer exposure to the corporate bond sector, these are relatively new with very small assets and trading volume, which can have a negative impact on trading efficiency and therefore performance.

In our opinion, currently the most preferable way to gain exposure to EMD is through mutual funds. The disadvantage of higher fees and tax inefficiencies can be partly offset by a larger variety of subsector alternatives with statistically valid track records. Providers may allocate broadly to a combination of dollar and local

Table 4: Impact of adding EMD to a traditional portfolio*

Source: MPI, IMG *Based on performance data between 2006-2014. **In equal weightings of 10% each. U.S. bonds represented by the BofA Merrill Lynch US Broad Market Index and U.S. stocks by the S&P 500 TR Index. Past performance is not a guarantee of future results.

Traditional Portfolio

10% EMD (USD Svgn)

Allocation

10% EMD (Local Svgn)

Allocation

20% EMD (USD + Local)

Allocation**

U.S Bonds 40% 36% 36% 32%

U.S. Stocks 60% 54% 54% 48%

EMD 0% 10% 10% 20%

Annualized Returns 7.08% 7.17% 7.15% 7.23%

Volatility 9.3% 9.1% 8.5% 8.3%

Max Drawdown -32.8% -30.9% -29.3% -27.3%


currency debt or offer specialized funds focusing on a particular type of EMD. It is imperative that investors analyze the holdings of the funds and understand the different risks they entail.

Another difference between ETFs and mutual funds is how they typically behave in up and down markets. By construction, ETFs generally utilize the more liquid issuers in the space. That fact, combined with mutual funds’ ability to use derivatives to access illiquid markets as well as “arbitrage” positions, can give the latter a performance edge in upward trending markets. But that same flexibility can work against active managers when markets sell off in an orderly way. An important caveat is that in the case of a disorderly sell-off, as was the case in 1998 with the Russian default or in 2001 with the Argentinian default, a mutual fund manager may be able to avoid exposure to the country in question advance of the event, while ETFs cannot.

That brings us to some other potential benefits of active management. The traditional investment approach has been to consider emerging markets as a monolithic segment, when in fact there is tremendous diversity among EM countries. The differences provide actively managed vehicles the opportunity to take advantage of not just overall growth in the area, but also to capitalize on relative value plays between faster and slower growing EM countries, discrepancies in risks and currency valuations.

As EMD becomes a strategic allocation in investors’ portfolios, tactical allocation between ETFs and mutual funds can be used as a source of further added value.

Table 5 highlights the unique characteristics of the different

vehicles discussed above. It is also important to remember that providers increasingly offer hybrids products that mix one or more of the risk factors outlined throughout this paper.

ConclusionThe emerging market debt space has evolved substantially over the past two decades from a small, largely tactical segment to an important and increasingly strategic element of the fixed income universe. Driven by stronger growth prospects and improving risk profiles that contrast sharply with economic conditions in the developed markets, we expect the EMD sector to continue to grow and offer investors potentially strong returns in select sectors.

Investors interested in the EMD story have three main choices: dollar-denominated sovereign debt, dollar-denominated corporate debt and local-currency sovereign bonds. Each segment has different drivers of risk and returns making each a potentially valuable source of diversification in a traditional portfolio.

Just as the EMD sector has grown so have the vehicles available to gain exposure to it. Investors can choose from a wide range of products ranging from ETFs, CEFs and mutual funds to hedge funds and SMAs. As the EMD sector continues to develop, investors can expect continued innovation from asset managers.

As the fallout from the financial crisis continues and investors increasingly challenge long-held assumptions about the emerging and developed markets, we feel EMD will continue to grow in strategic significance among a wider pool of investor portfolios.

Table 5: Comparison of different EMD investment vehicles

Source: IMG.

Investment VehicleSeparate Managed

Account (SMA)Exchange Traded

Fund (ETF)Hedge Funds

(HFs) Closed-end Fund (CEF) Mutual Fund (MF)

Subsector Access Customized to clients’ need

High HighVery limited (mainly USD EM sovereigns only)

High

Minimums $50MM. Can find for less but limited options

Low High Low Low

Liquidity High, but can impact performance

High LowHigh but need to be aware of NAV premium/discount

High


Bank of America Merrill Lynch can assist you with today’s more complex financial markets. Our Global Institutional Consultants can work with your organization to help you meet the demands of institutional investing. To learn more about Bank of America Merrill Lynch Global Institutional Consulting visit us at www.baml.com/institutionalconsulting or e-mail us at [email protected]

References Brauer, J. (2014, July 10). Size and structure of Global Emerging Markets debt. BofA-ML Global Research.

Comelli, F. (2012). Emerging Market Sovereign Bond Spreads: Estimation and Back-testing. International Monetary Fund Working Paper.

Davis, P. (2011, July 24). Emerging markets hedge funds start to blink on the radar. Financial Times.

Dollar or local? Unraveling the complexities of emerging market debt. (2012). Pictet Asset Management.

Harper, R. & Krom, B. (2013). Exploring Emerging Market Debt. Journal of Indexes.

Kozhemiakin, A. (2009). Emerging Markets Local Currency Debt: Capitalizing on Improved Sovereign Fundamentals. BNY Mellon Asset Management.

Mahanti, S., Nashikkar, A., Subrahmanyam, M., Chacko, G. & Mallik, G. (2008).

Latent liquidity: A new measure of liquidity, with an application to corporate bonds. Journal of Financial Economics.

Mauro, M. & Richardson, E. (2012, December 10). Get shorter, but not short. BofA-ML Global Research.

Miyajima, K., Mohanty, M. & Chan, T. (2012). Emerging market local currency bonds: diversification and stability. BIS Working Papers.

Reinhart, C. & Rogoff, K. (2010). Growth in a Time of Debt. American Economic Review, 100 (2).

Stewart, R. et al (2012). Emerging Market Debt: An asset class whose time has come.

JP Morgan Asset Management

Valluri, A. & Alexandre, C. (2011). Strategic Emerging: The role of emerging markets in a long-term portfolio. JP Morgan Asset Management.

Important Disclosure Information This piece was prepared by GWM Investment Management & Guidance (IMG). IMG provides investment solutions, portfolio construction advice and wealth management guidance.

The opinions expressed are those of IMG only and are subject to change. While some of the information draws upon research published by BofA Merrill Lynch Global Research, this information is neither reviewed nor approved by BofA Merrill Lynch Global Research. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. This information and any discussion should not be construed as a personalized and individual recommendation, which should be based on your investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. The information does not take into account an investor’s individual risk tolerance, time horizon, objectives and liquidity needs.

This material contains forward-looking statements about plans and expectations for the future. These statements may be identified by the use of words such as “may,” “can,” “will,” “expect,” “anticipate,” “estimate,” “believe,” and “continue”. These statements are based on current plans and expectations. There is always the risk that actual events may differ materially from those anticipated and that the forward-looking views may not come to pass. This document is current as of the date noted, is solely for informational purposes and does not purport to address the financial objectives, situation or specific needs of any individual reader. Market information provided herein was generally prepared by sources unrelated to Merrill Lynch. Such information is believed to be reasonably accurate and current for the purposes of the illustrations provided but neither Merrill Lynch nor any of its affiliates has independently verified this information. Opinions and estimates expressed herein are as of the date of the report and are subject to change without notice.

The investments discussed have varying degrees of risk. Fixed income investments are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.

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Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.

You should carefully consider the investment objectives, risks, charges and expenses of mutual funds, ETFs and CEFs before investing. This and other important information is included in the prospectus, which should be read carefully before investing. Prospectuses can be obtained from your investment professional. Information in this material is not intended to constitute tax advice. You should consult your tax advisor before making any financial decisions.

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Index Definitions Indices are unmanaged and their returns do not include sales charges or fees, which would lower performance. It is not possible to invest directly in an index. They are included here for illustrative purposes. Performance represented by a hedge fund index is subject to a variety of material distortions, and investments in individual hedge funds involve material risks that are not typically reflected by an index, including the “risk of ruin.” The indices referred to herein do not reflect the performance of any account or fund managed by Merrill Lynch or its affiliates, or of any other specific fund or account, are unmanaged and do not reflect the deduction of any management or performance fees or expenses. One cannot invest directly in an index.

The BofA Merrill Lynch Global Emerging Markets Sovereign Plus Index: Tracks the performance of USD and EUR denominated emerging market and cross-over sovereign debt publicly issued in the eurobond, euro domestic or US domestic markets.

The BofA Merrill Lynch Global Government Index: Tracks the performance of investment grade sovereign debt publicly issued and denominated in the issuer’s own domestic market and currency. In order to qualify for inclusion in the Index, among other criteria, a country (i) must be an OECD member and (ii) must have an investment grade foreign currency long-term sovereign debt rating (based on an average of Moody’s, S&P and Fitch

The BofA Merrill Lynch Local Debt Markets Plus Index: Tracks the performance of sovereign debt publicly issued and denominated in the issuer’s own domestic market and currency other than the more established top-tier sovereign markets.

The BofA Merrill Lynch US Broad Market Index: Tracks the performance of US dollar denominated investment grade debt publicly issued in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities.

The BofA Merrill Lynch US Corporate Index: Tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch).

The BofA Merrill Lynch US High Yield Index: Tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch).

The BofA Merrill Lynch US Municipal Securities Index: Tracks the performance of US dollar denominated investment grade tax-exempt debt publicly issued by US states and territories, and their political subdivisions, in the US domestic market.

The BofA Merrill Lynch US 3-Month Treasury Bill Index: Is comprised of a single issue purchased at the beginning of the month and held for a full month. At the end of the month that issue is sold and rolled into a newly selected issue.

The BofA Merrill Lynch US Treasury & Agency Index: Tracks the performance of US dollar denominated US Treasury and non-subordinated US agency debt issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch).

The MSCI Emerging Markets Index: Is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

S&P 500 Index: The S&P 500 Total Return Index is a market-weighted index that measures the total return, including price and dividends, of 500 leading companies in leading industries of the U.S. economy. This index is often used as a reference for the performance of the U.S. equities market.

The indexes referred to in the paper do not reflect the performance of any account or any specific fund, and do not reflect the deduction of any management or performance fees, or expenses. One cannot invest directly in an index. The indexes shown are provided for illustrative purposes only. They do no represent benchmarks or proxies for the return of any particular investable product. The alternative universe from which the components of the indexes are selected is based on funds that have continued to report results for a minimum period of time. This prerequisite for fund selection interjects a significant element of “survivor bias” into the reported levels of the indexes, as generally, only successful funds will continue to report for the required period, so that the funds from which the statistical analysis or the performance of the indexes to date is derived necessarily tend to have been successful. There can, however, be no assurance that such funds will continue to be successful in the future.

Merrill Lynch assumes no responsibility for any of the foregoing performance information, which has been provided by the index sponsor. Neither Merrill Lynch nor the index sponsor can verify the validity or accuracy of the self-reported returns of the managers used to calculate the index returns. Merrill Lynch does not guarantee the accuracy of the index returns and does not recommend any investment or other decision based on the results presented.

Technical TermsAnnualized return: The return on an investment that is re-scaled to a period of 1 year. Annualized returns represent a geometric mean and are calculated against the initial investment. Annualizing investment returns allow investors to compare the performance of assets that they have owned for different lengths of time.

Bear Market: A condition marked by increased pessimism in the market as reflected in falling security prices. Many consider a 20% or more fall in prices in multiple broad market indexes a bear market.

Bond Duration: Mathematically, it is a measurement of how long, in years, it takes for the price of a bond to be repaid through its coupon payments. The higher the internal cash flow of a bond the lower its duration, and vice versa. Duration can also be used to measure the sensitivity of a bond to changes in interest rates.

Bond Yield: A measure of the return on a bond. In the simplest case yield is calculated by dividing the coupon amount by the bond price, where the coupon value is the interest rate offered by the bond multiplied by its face value. So, if you buy a bond with a 5% coupon and a par value of $100,000, the bond yield is 5% ($5,000/$100,000). The yield changes with the price of the bond.

Bull Market: A condition marked by increased confidence and optimism in the market as reflected in rising security prices. Many consider a 20% or more rise in prices in multiple broad market indexes a bull market.

Closed-end funds (CEF): A type of registered investment company (RIC). Other types of RICs include mutual or open-end funds, exchange-traded funds (ETFs) and unit investment trusts (UITs). Like a traditional mutual fund, a CEF is an investment company that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives. However, unlike a mutual fund, a CEF issues a fixed number of shares through an IPO. Investors who want to buy or sell fund shares after an IPO do not purchase or redeem them directly from the fund; rather, they buy or sell fund shares on a stock exchange in a process identical to the purchase or sale of any other listed stock.

Correlation: Measures the extent of linear association of two variables. It quantifies the extent to which the fund and a comparative index-move together.

Developed Markets: Refers to high-income economies with a very high Human Development Index (HDI). For the purpose of this paper developed markets include those countries that comprise the Organization for Economic Co-operation and Development (OECD).


Technical Terms (cont’d)Effective Yield: The higher yield an investor receives relative to a bond’s nominal yield, arising from the reinvestments of all coupons (interest payments). The effective yield takes into account the effect of compounding.

Emerging Markets: Refers to countries whose economies are developing rapidly and are in the process of transitioning from agrarian to industrialized societies. They include the countries of Africa, Latin America, Eastern Europe, the Middle East and Asia—excluding Japan. For the purpose of this paper emerging markets includes those countries that are included in the BofA-ML Global Emerging Markets Sovereign Plus Index, BofA-ML Local Debt Markets Plus Index and BofA-ML Emerging Markets Corporate Plus Index that are not OECD members.

Exchange-Traded Fund (ETF): A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

Max Drawdown: A term used to describe a peak to trough decline during a specific time period.

Purchasing Power Parity (PPP): The exchange rate that equalizes the purchasing power of different currencies by eliminating the differences in price levels between countries. The economic concept behind PPP holds that in competitive markets identical goods in different countries should have the same price when valued in the same currency (otherwise the opportunity for arbitrage would exist).

Quasi-sovereign debt: Refers to securities issued by an agency or company that enjoys government backing.

Separately Managed Accounts (SMA): Is an individual managed account offered typically by a brokerage account.

GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.

This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client’s investment objectives, risk tolerance, liquidity needs and financial situation. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized.

Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.

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