A Bubble in Emerging Market Debt?

Emerging market debt has been a fantastic investment over the past five years, but what should we expect in the next five years?

Jose Garcia-Zarate 12 September, 2012 | 7:00AM

Emerging market debt has been one of the best performing assets during the last five years. Many investors are running scared from troubled developed markets where default risk is rising and they’re also tired of ultra-low yields offered by the likes of the US, Germany and the UK. Therefore, these investors have found an oasis of sorts in emerging market debt. The combination of improved credit quality, yield pick-up and the potential to enhance returns via currency plays has proved too tempting to ignore. As a result, active and passive funds offering exposure to emerging market debt now routinely make up a large portion of “Top 10” lists. However, as the first solid signs of trouble in emerging market economies arise (e.g. China slowdown), it is perhaps wise to question whether it makes sense to continue betting on stellar performance from emerging market debt going forward.

To assert that we are on the cusp of a market bubble is perhaps too controversial. However, what seems pretty clear is that current emerging market debt market valuations tell the tale of a crowded trade

The strength of money flows into this asset class over the last few years has pushed yields to levels which are not only low on a historical basis, but perhaps also indicative of miscalculation of risk. To assert that we are on the cusp of a market bubble is perhaps too controversial. However, what seems pretty clear is that current emerging market debt market valuations tell the tale of a crowded trade. Rationally this means that investors considering emerging market debt at present are unlikely to enjoy the same level of high returns in the future while possibly taking on an unsuitably high level of risk relative to their personal circumstances.

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About Author

Jose Garcia-Zarate

Jose Garcia-Zarate  is a senior ETF analyst with Morningstar Europe.

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