Trading Floor Notes: Emerging Market Debt and Liquidity

Steven Hoppe, Senior Fixed Income Trader
Colin Dowdall, CFA, Head of Insurance Solutions

Colin Dowdall:
Within the emerging market corporate debt (EMD) sector, the topic of liquidity comes up from time to time. The questions we field from clients and prospects reveal that misconceptions persist about the fluidity and scope of trading in EMD. We are frequently asked about the level of assets we can regularly invest seamlessly in the EMD. To gain a hands-on perspective regarding EMD liquidity, I sat down with our experienced EMD trader, Steve Hoppe.

Steve, investors' perceptions on EMD liquidity may be deeply rooted in prior periods of stress in the asset class—perhaps the global financial crisis, the "taper tantrum" of 2013 and even March of 2020 as the reality of COVID-19 hit the markets. Are these views valid in today's market? How do you respond to investors that wonder if they have to accept liquidity disruptions if they invest in EMD?

Steve Hoppe: From my perspective, it is false to think of EMD liquidity as subject to intermittent disruptions. Supply and demand in the market has grown dramatically. From the demand side, there has been a favorable expansion in the variety of accounts dedicated to emerging market investing. Industry flows data focuses on mutual funds, which can be quite volatile. However, other larger pools of investors such as pensions, insurers and sovereign wealth funds are also putting money to work in these markets. This broadening in the demand base has enhanced liquidity for EMD.

On the supply side, the EMD asset class is a sizable $2.5 trillion, significantly larger than the US high yield sector ($1.3 trillion). Looking back, EMD market value is close to five times the size it was during the global financial crisis and more than $1 trillion higher than it was during the 2013 taper tantrum. When we add EM sovereign credit ($1.5 trillion) to the equation, we are really talking about a robust opportunity set.¹

Secondly, when stresses occur in the market in general or in certain regions, there are large remaining swaths of the EMD market where investors can find liquidity and potential. For example, a broad risk-off move can provide opportunities to add exposure in various credit-rating tiers that may show disconnects in valuation. Importantly, emerging markets can be found in multiple regions—Asia, Latin America, Central Europe, the Middle East and Africa. As a trader, it is essential to understand the "buyer pockets" across the regions. For example, there are various estimates, but one that seems reasonable to me is that 80% of Asian credits are held in Asia. Another strong source of internal support for regional bonds is in the Middle East. In the recent market risk-off move following the Iran missile attack on Israel, we saw regional players step up to buy bonds across the Gulf Cooperation Council countries. In each of the EMD regions, I typically see baskets of companies (10 to 30) that trade healthy volumes from $25 million to $100 million in corporate bonds daily (US dollars).

What is your current read on emerging market (EM) credit liquidity?

In my view, so far this year liquidity in EM has been the best that it has been in recent years given the breadth of market participants (looking for yield and spread) and the different tools to access the market. Globally, there is a wide array of options to buy EM sovereigns, corporates, local market debt and derivatives, which has continued to develop each year. Our daily and weekly trade flows for EM credit have grown 20% and 25%, respectively, through March 2024. Internally, our trading desks rate liquidity by asset class. We saw EM credit and US high yield liquidity mostly aligned earlier in the year, but since March, EM credit liquidity has improved, while the measure for high yield has been more sideways.

Steve, what do you see driving liquidity in the EMD sector in 2024?

To date, we are seeing a rebound in the crossover bid for EM. Investors include those with developed markets indices—investment grade or high yield—looking to buy EM issuers in their index and/or take off-benchmark exposure to add incremental spread or beta to their portfolios. This year, we have seen interest return from this investor group, especially for high-quality EM issuers as spreads for developed markets continue to compress. Additionally, we have experienced a far more active new-issue calendar this year than in 2023. New issuance (through April 2024) reached 58% of full-year 2023 issuance. Issuance from Latin America has been particularly strong and some of these issuers are very well known to the crossover investor.²

From where I am sitting, it seems investors have come to realize that EM corporate debt can offer a diversifying set of risk factors that can give portfolios access to more corporate issuers with a spread premium we have seen over time offered by the asset class.

Moving beyond liquidity, when you meet with institutional investors, what other EMD-related themes do you hear?

While EM debt yields can be attractive, the institutional investors making the decisions—those answering to investment boards—know there has to be more to an investment than just a yield advantage. There have to be compelling fundamentals with advantageous growth potential. Investors seem to be more aware of the relative growth prospects in the emerging markets. In aggregate, EM growth continues to hold up well compared to developed market countries, as was recently affirmed by the IMF in its April forecast update³. Investors have also come to understand that investing in EMD corporates offers a universe where credit metrics rival or are possibly better than their developed market peers. In my view, the diversification properties and risk/return profiles provided by EMD investments can make them an attractive option for investors responsible for making allocations within multi-asset portfolios.

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