Lazard Perspectives

Investment Grade Emerging Markets Debt: A Source of High Quality YieldIn an era of financial repression, identifying sources of high quality yield in the $100 trillion global fixed income market is like searching for a needle in a haystack. The search for yield has forced investors further out on the risk spectrum, dramatically bringing down yields across investment grade and sub-investment-grade fixed income sectors.

Investment grade emerging markets debt stands out as a source of high quality yield for investors who are willing to look beyond developed markets investment grade sovereign and corporate markets for attractive income opportunities. Lazard’s Emerging Markets Debt team explores this concept, including the potential benefits of adding emerging markets debt to an existing asset mix.

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Although fixed income yields have risen over the past several months, a significant share of the global bond market continues to trade at negative yields. The total stock of negative-yielding debt peaked at nearly $13 trillion in July 2016, and is currently slightly more than $9 trillion (Exhibit 1). Investment grade developed markets fixed income benchmarks are heavily exposed to negative yields, with about one-fifth of global developed markets government bonds yielding less than zero.1

Hard currency investment grade sovereign and corporate emerging markets bonds have offered a substantial yield pickup over their developed markets counterparts (Exhibit 2). With yields in excess of 4%, these classes of emerging markets debt have offered additional yield compensation over developed markets corporate debt of similar credit quality and duration, ranging from 0.8%–2.5%. The yield advantage has been similarly compelling relative to broad investment grade indices at 1.5%–2.5%.

The relative attractiveness of investment grade emerging markets debt yields directly relates to the asset class’s higher spreads. While spreads have tightened across all sectors since the height of the global financial crisis in 2008, emerging markets spreads began diverging from developed markets spreads in the spring of 2013, during the “taper tantrum” (Exhibit 3). Emerging markets, especially investment grade debt, suffered disproportionately as fears of an abrupt end to the Federal Reserve’s quantitative easing program and the expectation of subsequent US rate hikes led to concerns about emerging markets capital outflows. Although these fears abated in relatively short order, investor attention quickly shifted to the negative implications of slowing Chinese growth and the sharp, prolonged drop in commodity prices on emerging markets fundamentals.

Although commodity prices have rallied significantly from their historic lows and emerging markets fundamentals have been improving for the past several quarters, emerging markets debt valuations have yet to return to their historical levels relative to developed markets. Prior to the taper tantrum, emerging markets generally offered additional spread compensation of 60–70 basis points (bps) over developed markets, in contrast to today’s excess spread of roughly 85 bps. An additional 20 bps of spread on average may not seem significant, but every basis point matters in today’s low yield environment, especially considering the additional upside potential should spread differentials revert to historical averages.

Favorable Growth DifferentialOver the past several months, our analysis of economic indicators—which includes economic growth, fiscal balances, and debt to GDP—suggests to us that emerging markets fundamentals are improving and compare favorably to developed markets. We believe the most important of these indicators is economic growth, which,

Exhibit 1Total Negative-Yielding Debt Stock Remains High

5

7

9

11

13

Mar2017

Jan2017

Nov2016

Sep2016

Jul2016

May2016

Mar2016

Jan2016

Total negative-yielding debt stock ($T)

As of 31 March 2017

Source: J.P. Morgan

Exhibit 2Attractive Yields Relative to Alternatives of Similar Quality and Duration

Yield to Worst (%)

Average Quality

Duration (Years)

EM Corporate – Investment Grade 4.07 BBB+ 5.37

EM Sovereign – Investment Grade 4.26 BBB+ 7.55

50% EM Corporate/ 50% EM Sovereign

4.17 BBB+ 6.46

US Corporate – Investment Grade 3.33 A-/BBB+ 7.33

European Corporate – Investment Grade

0.90 A-/BBB+ 5.38

US Fixed Income 2.61 AA+/AA 6.00

Global Fixed Income 1.64 AA- 6.97

As of 31 March 2017

See notes for underlying indices.

Source: Lazard, Bloomberg Barclays, J.P. Morgan

Exhibit 3Emerging Markets Spreads Decoupled from Developed Markets in 2013

Spread (bps)

60

160

260

360

2017201620152014201320122011

Taper Tantrum

EM Corporate – IGEM Sovereign – IGEuropean Corporate – IG

US Corporate – IGUS Fixed Income Global Fixed Income

As of 31 March 2017

See notes for underlying indices.

Source: Lazard, Bloomberg Barclays, J.P. Morgan

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after several years of declines, stabilized in 2016 and is expected to rebound nicely in 2017 on an absolute basis (Exhibit 4) and relative to developed markets. Many factors underpin this improvement, including stable-to-rising commodity prices and low-base effects, as well as improving domestic demand and rising consumer confidence in a number of emerging markets countries. Growth differentials are expected to widen in favor of emerging markets and we believe this is likely to drive the outperformance of emerging markets debt in the months and years ahead.

Tackling Rising YieldsTwo of the factors that have anchored interest rates in recent years—disinflation and highly accommodative central bank policy—appear to be fading and may even reverse. Moreover, yields have much more room to rise than they do to fall. This forces investors to consider ways to defend their fixed income portfolios against rising interest rates.

The cushion against rising rates has been considerably thicker in emerging markets debt relative to developed markets. For example, a mere 24 bps increase in yields would completely wipe out an entire year’s worth of carry on the Bloomberg Barclays Global Aggregate Index (Exhibit 5). It would take even less to do the same for European corporates. In contrast, as our research shows, an investment grade emerging markets debt portfolio that is evenly split between sovereign debt and corporate debt can absorb up to a 65 bps increase in yields before its returns would turn negative. The yield on emerging markets investment grade debt would have to approach 5% in order to completely erode its current carry. Since the global financial crisis, emerging markets investment grade yields have breached 5% on only a few occasions, such as the taper tantrum in May 2013 and when oil prices bottomed in early 2016. Importantly, each instance has been characterized by a brief spike in yields followed by a significant rally.

In a yield-starved environment, investment grade emerging markets debt can be a source of high quality yield, with lower valuations than developed markets investment grade fixed income. The buffer from emerging markets’ higher yields and lower duration is also a significant consideration in an environment where interest rate risk is skewed to the upside. The asset class’s attributes can address these timely concerns in addition to offering strategic asset allocation and return opportunities.

Diversification Adding emerging markets to an existing fixed income allocation may also enhance portfolio diversification and greatly broaden the opportunity set. There are large differences between emerging markets and developed markets fixed income indices. Although emerging markets debt is generally included in corporate bond indices and broader investment grade bond indices, the overlap of issuers tends to be only around 2%.

Exhibit 4Emerging Markets Growth Is Rebounding

Growth Differential, Emerging Markets vs. Developed Markets (%)

-2

0

2

4

6

8

2017E20142011200820052002

As of 31 March 2017

Source: Lazard, Bloomberg, Capital Economics

Exhibit 5Developed Bond Markets Carry can be Easily Negated

Rate increase needed to negate carry (bps)

0

20

40

60

80

GlobalFixed

Income

USFixed

Income

EuropeanCorp – IG

USCorp – IG

50% Corp/50% Sov

EMSov – IG

EMCorp – IG

As of 31 March 2017

See notes for underlying indices.

Source: Lazard, Bloomberg Barclays, J.P. Morgan

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While correlations will undoubtedly vary over shorter time periods, over the long term emerging markets debt has had relatively low correlations to developed markets fixed income (Exhibit 6). Thus, by adding a dedicated allocation to investment grade emerging markets debt to an existing fixed income mix, investors may be able to improve their risk-adjusted returns (Exhibit 7).

Generous Opportunity SetThe investment grade emerging markets debt universe is broad and deep, spanning both the external sovereign and corporate bond markets. As the asset class has evolved and grown, so too has the opportunity set. Notably, the external sovereign debt market has undergone a structural re-rating. In the late 1990s less than 15% of the then-fledgling market was investment grade. Today, over one-half of external emerging markets sovereign debt is rated investment grade. Emerging markets corporations have increasingly gained access to international capital markets, allowing them to issue debt in hard currencies and further expanding the opportunity set for investors.

Although countries such as Russia, Brazil, and Turkey have lost their investment grade rating in the past few years, we believe the investment grade emerging markets debt universe continues to offer a wealth of opportunity. When J.P. Morgan formally launched its family of corporate indices in 2008, the investment grade emerging markets debt universe comprised about $275 billion in outstanding debt from 28 countries and approximately 150 issuers. Today, the market stands just shy of $1 trillion in debt outstanding across 40 countries and more than 350 issuers (Exhibit 8).

Notably, we believe these figures are fairly conservative as they are based on J.P. Morgan�s widely followed bond indices and exclude countries that do not meet its emerging markets criteria. Investment grade countries such as Slovenia and Saudi Arabia may offer attractive off-benchmark opportunities. Saudi Arabia has over $25 billion in sovereign debt outstanding with a credit rating of A1/A+2 and its 10-year bond currently yields over 3.5%, with a spread of 135 bps over US Treasuries. Additionally, we see potential for large issuers such as Russia and Brazil to regain their investment grade status over the next few years, which is likely to result in upgrades for many corporate issuers in these countries, which will only serve to widen the universe of potential investments.

Strategic ConsiderationsInvestors in search of higher yields are likely already familiar with emerging markets debt. In our experience, they have typically opted for one of two approaches, namely a “plus” allocation within a broader fixed income mandate or a dedicated allocation to emerging markets debt across the ratings spectrum, from investment grade to sub-investment-grade. For investors who are ratings-constrained or who wish to avoid the lowest tranches of credit quality, we believe a dedicated allocation to investment grade emerging markets debt

Exhibit 7An Emerging Markets Bond Allocation Can Improve a Portfolio’s Position on the Efficient Frontier

Return (%)

2 3 4 5 62

3

4

5

Volatility (%)

100% US FI

75% US FI/25% EM IG

50% US FI/50% EM IG

25% US FI/75% EM IG

100% EM IG

Measures a five-year period from 31 March 2012 to 31 March 2017

The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent the performance of any product or strategy managed by Lazard. It is not possible to invest directly in an index.

Source: Lazard, Bloomberg Barclays, J.P. Morgan

Exhibit 8The Investment Grade Emerging Markets Debt Universe Has Grown Rapidly

(%)

0

400

800

1,200

20172015201320112009200720052003

EM Corporate – Investment GradeEM Sovereign – Investment Grade

As of 31 March 2017

Source: Lazard, Bloomberg Barclays, J.P. Morgan

Exhibit 6Lower Correlations to Developed Markets Fixed Income

50% EM Corp/

50% EM Sov

US Corp – IG

Euro Corp – IG

US Fixed

Income

Global Fixed

Income

50% EM Corp/50% EM Sov 1 0.63 0.52 0.55 0.52

US Corp – IG 1 0.71 0.91 0.85

European Corp – IG 1 0.59 0.72

US Fixed Income 1 0.93

Global Fixed Income 1

Period from 31 December 2002 to 31 March 2017

The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent the performance of any product or strategy managed by Lazard. It is not possible to invest directly in an index.

See notes for underlying indices.

Source: Lazard, Bloomberg Barclays, J.P. Morgan

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provides a good source of high quality yield, especially in today’s environment.

Relative to developed markets, the emerging markets investment grade bond universe compares favorably from both a valuation and fundamental standpoint, while offering portfolio diversification potential. The higher spreads associated with investment grade emerging markets debt have also historically offered greater protection against rising interest rates. In order to preserve these positive attributes, however, we generally suggest investment grade emerging markets debt portfolios focus on sovereign and corporate hard currency debt in order to avoid the volatility associated with local currency markets.

We understand the vital importance of engaging the right areas of emerging markets debt in order to achieve desired investment outcomes. With an average of 21 years of experience investing across the asset class spectrum, our team is well versed in the investment grade emerging markets debt opportunity. In particular, we are able to capture this opportunity in a single portfolio by investing in high quality emerging markets sovereign and corporate bonds, which are at the heart of our emerging markets hard currency and corporate bond portfolios.

About Us

The Lazard Emerging Markets Debt team focuses on understanding the entire opportunity set in our investment universe. We combine our expertise with the benefits of access to Lazard’s broader emerging markets platform. We seek to deliver comprehensive insight to our investors, through research into currency movements, the stability of equity and debt structures, and the broad business environment.

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This material is provided by Lazard Asset Management LLC or its affiliates (“Lazard”). There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past per-formance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. Investments in securities and derivatives involve risk, will fluctuate in price, and may result in losses. Certain securities and derivatives in Lazard’s investment strategies, and alternative strategies in particular, can include high degrees of risk and volatility, when compared to other securities or strategies. Similarly, certain securities in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect invest-ment performance.

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LR28167

IndicesEM Corporate – Investment Grade = J.P. Morgan CEMBI Broad Diversified Investment Grade; EM Sovereign – Investment Grade = J.P. Morgan EMBI Global Diversified Investment Grade; US Corporate – Investment Grade = Bloomberg Barclays US Corporate; European Corporate – Investment Grade = Bloomberg Barclays European Aggregate Corporate; US Fixed Income = Bloomberg Barclays US Aggregate; Global Fixed Income = Bloomberg Barclays Global Aggregate

Notes1 As of March 2017. As measured by the J.P. Morgan GBI-DM Index.

2 Moody’s/Fitch ratings

Important InformationPublished on May 9, 2017.

Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change.

An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions.

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.