The overlooked gem that’s not in Australian portfolios

The broadening menu of yield-bearing investments available to Australian investors in recent years has given much broader scope for diversified allocations. But there is one segment that is noticeable by its absence.

Areas such as corporate and securitised debt issuance have grown in useage, a private credit in particular has ballooned in the past three years as an alternative investment to traditional fixed income. But there is a sector of the interest-bearing market that has not enjoyed the same popularity, and that’s emerging market debt (EMD).

The main reason for this is that – whether one is talking equities or fixed income – emerging markets have long suffered the misconception of being “riskier” for investors than developed-markets (DM) equities or debt. But the rationale in both cases is that, based on the Efficient Frontier framework and Sharpe ratio, an allocation to emerging markets can in fact help investors achieve better risk-adjusted returns.

ETF provider Van Eck puts it well, saying: “The irony is that many of the negative characteristics commonly associated with emerging markets, such as highly indebted governments, gross budget deficits, and loose monetary policy, are more accurately attributed to developed markets – a shift that has become particularly pronounced in light of the a shift that has become particularly pronounced in light of the US’ burgeoning debt.”

In fact, the fiscal circumspection of many countries in the Asia, Latin America and Eastern Europe regions stands out for having low inflation and stable currency settings, which in turn is flowing through to sustainable growth. Many arguably have much sounder footings than their developed-market counterparts.

As that misconception of greater riskiness has been blown away, the emerging markets debt (EMD) asset class has become an US$8 trillion ($12.1 trillion) asset class, representing about 11 per cent of the global bond market. To put that in perspective, the global high yield market is about US$4.5 trillion ($6.8 trillion) in size.

But it is not a story well-grasped in Australia. “Many Australian investors’ fixed income portfolios do not include an allocation to emerging markets (EM) bonds,” says Van Eck in a recent white paper, titled: ‘Emerging Strength: Why EM Bonds are the future of fixed income.’ Over the past 25 years EM governments have gone from being in deficit to running up surpluses while developed market (DM) governments have been accruing deficits. This change has resulted in a shift in the origin of bond crises since the turn of the millennium.” But fixed income portfolios have yet to reflect what has become the new reality since the turn of the century, says the ETF issuer.

VanEck’s vested interest is to garner investor interest in its active emerging markets bonds ETF, VanEck Emerging Income Opportunities Active ETF (ASX: EBND): the issuer believes that taking full advantage of the opportunities in emerging markets debt requires an unconstrained active approach. But it points out that even without active management, EBND’s benchmark – a 50:50 split of the J.P. Morgan Emerging Market B ond Index Global Diversified Hedged AUD and the J.P. Morgan Government Bond-Emerging Market Index Global Diversified – has outperformed major DM global bond markets in the more than five years (from February 2020) of EBND’s existence.

EMD can be both hard-currency (mainly issued in US$) or in the issuing country’s or company’s local currency. Over the years, denominating debt in a hard currency like USD has been seen as reducing the currency risk for investors, as they are not exposed to fluctuations in the issuer’s local currency, but EM local currency debt now attracts far greater investor interest, with narrower pricing (that is, tighter spreads) indicating reduced risk perception and potential for higher returns compared to hard currency debt. This trend is driven by factors like a weaker US dollar, improved economic fundamentals in emerging markets, and a search for yield as developed markets offer lower return.

As global funds manager Robeco puts it, local-currency EMD “had a lost decade” due to a strong US dollar, but the decline of the greenback since the “Liberation Day” tariff announcement has changed things quickly. With the US Dollar Index down 10.4 per cent this year, local-currency EMD is “currently valued cheaply,” in Robeco’s view.

Even before the 2025 slide in the greenback, many large EM countries, such as Brazil, China and India, had become able to issue government debt in local currency. Robeco says the local-currency EM government bond segment has grown much faster than the hard-currency segment, and is currently valued at more than US$5 trillion ($7.6 trillion), leaving the hard-currency government segment well behind, at about US$1 trillion ($1.5 trillion).

Both hard-currency and local-currency EMD can be attractive additions to multi-asset portfolios, says Robeco.

MetLife Investment Management holds a similar view, saying the diversification characteristics of EMD in all its forms, from sovereign, corporate and local, should be considered as a useful tool in portfolio construction. MetLife says emerging markets may be “uniquely positioned to help portfolios with income and return potential,” within a world of many changes. 

“EMD offers the potential a combination of diversification, yield potential and resilience, making it a compelling option for investors seeking to navigate shifting global economic landscapes,” says MetLife. “Across sovereign, corporate and local debt, the asset class provides potential opportunities to leverage improving fundamentals, favorable technicals and attractive valuations – especially in an era when DM faces increasing headwinds.

Whether through a bond fund manager or an ETF such as VanEck’s EBND, the last word should belong to the ETF issuer; in the Australian context, it says, “zero is the wrong allocation for EM bonds.”