• Emerging market (EM) debt delivered double-digit returns in 2023, driven in part by a shortage of new issuance supply.
• A recent wave of new EM debt issuance has helped widen spreads and is providing a near-term opportunity for active investors to add exposure ‒ but security selection is critical.
• EM debt is uniquely poised to benefit from prospective rate cuts and strong ongoing demand for fixed income assets in the coming months, which we believe will drive EM outperformance in 2024.

Emerging market (EM) bonds delivered double-digit returns in 2023¹. Daniel Shaykevich, senior portfolio manager of the Vanguard Emerging Markets Bond Fund, looks at how EM debt is particularly well-positioned to continue outperforming other areas of fixed income in the year ahead, and explores Vanguard’s approach to leveraging new active EM opportunities to deliver strong returns for investors.

EM hard-currency sovereign bonds performed strongly in 2023, returning more than 11%². Returns were driven by improving country fundamentals and a supportive supply-demand dynamic. Much of the performance came from higher-quality issuers, with constrained levels of debt issuance causing EM investment-grade (IG) spreads to tighten over the course of 2023.

We used this opportunity to rotate out of EM IG into EM high-yield (HY) issuers, which offered compelling valuations coupled with improving fundamentals.  Additionally, we sought exposure in EM local currency bonds, which were supported by falling inflation and high real yields in EM economies.

January wave of new supply

Going into 2024, a wave of primary market issuance by EM countries has helped spreads to widen to more attractive levels. The large volume of new-issue supply, which is expected to abate in subsequent quarters, is providing a near-term opportunity for EM debt investors to add risk at more attractive levels, before further inflows begin to outpace supply.

Front loaded: 47% of forecasted 2024 investment-grade EM issuance was completed in January

Source: Bloomberg, JP Morgan and Vanguard; as at 31 January 2024. Full-year 2024 issuance based on forecasted figures.

Attractive relative-value opportunity

Our base case economic forecast for 2024 anticipates a supportive environment for fixed income in general, and for credit in particular, with stabilising inflation and slowing growth allowing many of the major central banks (including the US Federal Reserve, Bank of England and European Central Bank) to cut rates in 2024 and reduce recession risk.

After January’s spread widening, EM IG spreads are near their most attractive levels relative to US IG spreads in more than two years, while EM high-yield (HY) spreads remain attractive compared with US HY. With US credit valuations near historical highs, the compelling valuations of EM debt will make it a strong contender for investors’ fixed income allocations. We believe this sets up EM debt for outperformance in the coming year. 

EM credit spreads back to more attractive levels versus US credit spreads

(Ratio of EM spreads to US credit spreads)

Source: Bloomberg and JP Morgan, for the period from 1 January 2022 to 31 January 2024. The chart shows historical EM IG spreads relative to US IG spreads and EM HY spreads relative to US HY spreads.  Proxies used in ratios: EM IG: Investment Grade sub-index of the J.P. Morgan EMBI Global Diversified index; EM HY: High Yield sub-index of the J.P. Morgan EMBI Global Diversified Index; US IG: Bloomberg U.S. Corporate Bond Index; US HY: Bloomberg High Yield Corporate Index.

A differentiated asset class

In addition to attractive valuations, EM credit benefits from a unique combination of wide spreads and long duration, something that neither US IG nor US HY bonds can offer. This makes the asset class uniquely positioned to benefit from both falling interest rates and a stable economic growth environment that supports demand for higher-yielding debt. With strong investor demand for fixed income assets more broadly, and historically expensive valuations in US corporate bonds, EM debt is well-positioned to perform in 2024.

The benefits of active EM bond strategies

Even more than in other areas of fixed income, an active approach to EM debt can add additional value for investors without adding additional risk³. There are several factors that make EM assets particularly suitable for alpha generation through active security selection:

• EM assets tend to have longer duration profiles, meaning their returns are often driven by spread performance and not just their holding period returns (often referred to as their ‘carry’). As a result, choosing individual EM outperformers can really pay off.
• Fundamentally improving EM sovereign issuers can outperform for years if they remain on a positive trajectory, providing excess returns to investors for long periods.
• Larger EM countries have well-developed yield curves, and often include sovereign and quasi-sovereign issuers ‒ giving active investors a selection of instruments to implement country exposures.

Positioned for long-term performance

After a solid 2023, we believe EM credit is set to continue delivering strong outright and risk-adjusted returns in the near-term as well as on a longer-term basis. For investors with the appetite, active EM fixed income strategies with a security-selection focus can add alpha for a similar level of risk ‒ a thoughtful approach when adding exposure to this important asset class that can also generate excess returns for investors.

^1,2 Source: Bloomberg. Based on total returns for the J.P. Morgan EMBI Global Diversified index, for the period 1 January 2023 to 31 December 2023.

³ Source: Vanguard.