Boasting growth rates that would makes much of the developed world blush with envy, emerging market (EM) debt has become all the rage as of late. According to JP Morgan, pension funds are looking to place as much as $100 billion into the investment over the next five years.
To be sure, there are compelling reasons to own EM debt. Emerging economies are not as heavily levered as the developed world. According to Goldman Sachs, the debt to GDP ratio of emerging economies is less than 40%, compared to over 100% of many areas of the developed world. And as an increasing portion of the developed world has embraced capitalism, the relative stability of these economies is much greater than during the last EM debt defaults of the 1990s.
However, the risk of this investment should also be considered. As more investors take the EM debt plunge, asset managers trying to attract capital are being forced in the highest yields of the asset class–which are also the most unstable. Moreover, as spreads continue to fall, the risk-reward ratio of emerging market debt becomes less attractive.
Because of these risks, and the potential volatility that emerging market debt can generate in a portfolio, I consider an emerging markets debt investment as more of an equity substitute than a stable fixed income allocation. This mindset should allow advisors to more intelligently size their EM debt commitment.
