EM debt – Resilience over yields

EMERGING market (EM) debt is poised to attract greater attention from reserve managers, the officials responsible for safeguarding and investing national reserves.

The shift comes as higher bond yields, geopolitical uncertainty and concentration risk reshape the investment landscape, with central banks and sovereign wealth funds increasingly taking a fresh look at where EM debt fits within their portfolios.

According to Robert O Abad of Western Asset Management, a wholly-owned specialist fund manager under the Franklin Templeton group, the discussion is moving beyond the pursuit of yield and towards whether institutions possess the resources and expertise needed to navigate an increasingly complex asset class.

Large central banks and sovereign wealth funds are reviewing whether EM debt deserves a larger role in their portfolios as reserve management practices evolve.

Abad says the trend reflects a decade of change marked by ultra-low interest rates, sanctions risk, geopolitical tensions and a meaningful repricing of developed market (DM) bond yields.

“Large central banks and sovereign wealth funds are increasingly evaluating whether EM debt should play a larger role within their investment portfolios,” he says.

The growing interest coincides with rising allocations to gold and increased exploration of alternative assets.

However, Abad cautions against viewing EM debt simply as a higher-yielding investment opportunity.

“While EM debt can offer attractive yields, diversification benefits and, in some cases, currency appreciation potential, its practical application is more complicated than it first appears,” he says.

The asset class has changed dramatically over the past three decades.

Thirty years ago, the investable universe is much smaller, information is less accessible and a relatively limited number of countries drive most returns. Investors willing to undertake detailed country analysis and tolerate volatility are often rewarded.

“In many respects, it was a ‘go big or go home’ approach,” Abad says, describing a period when markets are less efficient and competition for opportunities is far less intense.

Today, the picture is markedly different.

The EM debt universe has expanded significantly as more sovereign issuers enter global bond markets, local capital markets mature and corporate borrowing increases.

The investor base has also broadened to include pension funds, insurers, sovereign wealth funds, exchange-traded funds and quantitative strategies.

That growth has created what Abad describes as a paradox.

“The EM opportunity set has never been larger, yet building a truly informed view of that opportunity set has arguably never been more difficult,” he says.

Not a single asset class

Modern benchmarks now contain dozens of sovereign issuers and hundreds of securities spanning different regions, political systems and stages of economic development.

Some countries boast strong institutions, favourable demographics and investment-grade balance sheets, while others grapple with fiscal pressures and political instability. Despite these differences, they often sit within the same benchmark.

“For reserve managers, this distinction is critical. EM debt should not be viewed as a single asset class.

“It is a collection of highly diverse countries operating under vastly different political systems, economic models, institutional frameworks, demographic profiles and geopolitical realities.”

Abad argues that institutional strength increasingly determines success. While discussions around EM debt often focus on risk and return, he believes organisational capabilities are equally important.

“One of the most overlooked aspects of investing in EM debt is that success often depends as much on institutional scale as it does on investment skill,” he says.

Larger reserve managers typically possess dedicated research teams, sophisticated risk controls and governance structures that support long-term investment horizons.

They also often have sufficient reserves to separate liquidity needs from investment objectives.

By contrast, institutions with limited excess reserves may face constraints that force decisions based on liquidity demands rather than long-term fundamentals.

According to Abad, scale allows investors to withstand periods of market volatility, maintain conviction and devote resources to understanding country-specific risks.

“The challenge is not simply finding opportunities.

“The challenge is filtering information, identifying what matters and maintaining conviction when markets move against a position.”

As a result, he says reserve managers should treat EM allocations as both an investment decision and an institutional decision.

“In many cases, the difference between success and disappointment in EM is not the quality of the asset itself; it is the quality of the institution making the allocation decision.”

Not every institution should pursue the strategy, he adds.

Reserve management is ultimately about aligning investments with objectives, governance standards and liquidity requirements, rather than following industry trends.

“For some institutions, particularly those with limited excess reserves, smaller investment teams or a mandate that remains heavily focused on liquidity and capital preservation, the costs and complexities associated with EM debt may outweigh the potential benefits.”

Resilience a priority

Abad also highlights a fundamental difference between reserve managers and traditional asset managers. While many investment firms focus on maximising risk-adjusted returns, reserve managers operate under broader responsibilities.

“Their objective is to preserve national wealth, maintain liquidity, support financial stability and generate reasonable returns within those constraints,” he says.

That mandate places greater emphasis on resilience and downside protection.

It also increases the information burden.

Reserve managers are now expected to assess geopolitical shifts, trade fragmentation, demographic changes, energy security and domestic political developments across multiple countries.

“More information does not necessarily produce better decisions,” Abad says, noting that much of today’s information is incomplete, contradictory or quickly outdated.

Because of these challenges, he believes the starting point for EM investing should be resilience rather than yield.

“Consequently, the decision to allocate to EM should not begin with yield. Yield is an outcome, rather than a starting point. The starting point should be resilience.”

Countries with fiscal discipline, institutional credibility, policy flexibility and political stability deserve closer attention than those simply offering higher yields, he argues.

The calculation becomes even more important as DM bond yields rise. Investors no longer need to move as far out on the risk spectrum to generate acceptable returns, meaning the threshold for taking additional risk is higher.

Abad also encourages reserve managers to look beyond sovereign issuers.

In some cases, quasi-sovereign or corporate issuers with stronger balance sheets and diversified revenue streams may provide better risk-adjusted opportunities than sovereign borrowers.

For institutions considering a first step into the asset class, he recommends gradual implementation.

“The decision to invest in EM debt does not need to be binary,” he says.

Pilot programmes, limited allocations and partnerships with external managers can help organisations assess their readiness before committing significant capital.

Such approaches also reveal how decision-makers respond when volatility rises and market conditions deteriorate.

Looking ahead, Abad says reserve managers should focus on selectivity, institutional quality, policy credibility, scenario analysis and disciplined risk management.

Ultimately, the conversation surrounding EM debt is evolving.

“The discussion has evolved beyond whether EM debt deserves a place in a portfolio,” he says.

“The more relevant consideration is whether reserve managers possess the framework, resources, governance structure and analytical depth necessary to identify which EM regions deserve capital in the first place,” he points out.