Emerging Market Debt and Currency Considerations (CFA Level 1): Sovereign vs. Corporate Emerging Market Debt, Growth of EM Corporate Issuance, and Unique Risks. Key definitions, formulas, and exam tips.
Emerging markets (EMs) can seem quite appealing if you’re looking for higher yields. I remember the first time I seriously considered investing in EM bonds: the yields were so much higher than those of developed-market Treasuries that I actually got a little suspicious. Turns out, those higher coupons often come bundled with heightened credit risk, currency volatility, and the possibility of unexpected political events.
Despite that extra layer of uncertainty, EM bonds have become a popular fixture in many global portfolios—especially among those willing to tolerate more risk in exchange for potentially higher returns. These securities typically come from jurisdictions that are still on their way to becoming fully developed, but they can offer a layer of diversification since their economic cycles aren’t always closely synced with, say, the U.S. or European markets. Let’s walk through how EM sovereign and corporate bonds work, how currency exposure can affect your bottom line, and what it really means when we talk about liquidity issues in these markets.
One key distinction in emerging market debt is whether you’re looking at sovereign bonds—those issued by governments—or corporate bonds, issued by companies based in these markets.
There’s been a notable shift over the past decade: EM corporate issuance has grown pretty fast. Historically, most investors focusing on EM debt only considered sovereign issuers, partly because corporate markets were less developed. But now, many EM corporations have sought funding on global capital markets. While this offers a richer set of opportunities, it also means analyzing both corporate and country-level risks (e.g., the sovereign ceiling, which suggests a corporate entity is typically rated no higher than its home-country government).
A second key classification in emerging market debt is whether you’re holding bonds denominated in a “hard” (or external) currency, such as U.S. dollars or euros, or whether the bonds are in the issuer’s local currency. Both categories have some interesting pros and cons.
| Feature | Hard Currency (External) Debt | Local Currency Debt |
|---|---|---|
| Currency Exposure | Minimal FX exposure if your base currency matches hard currency, though still subject to broader default risk. | Significant FX exposure; if your base currency differs from the issuer’s, you face exchange rate fluctuations. |
| Yield Levels | Typically lower relative to local currency bonds, but still higher than developed-market sovereigns. | Often higher yields to compensate for added currency risk. |
| Liquidity | Often more liquid because U.S. dollar- or euro-denominated bonds can trade widely among global investors. | May be less liquid; depends on local market sophistication and capital controls. |
| Credit Risk | Sovereign or corporate credit risk remains, but currency mismatch can be less of a concern for the issuer if they have stable foreign cash flows. | Issuers with local revenues may reduce mismatch risk, but foreign investors are fully exposed to exchange rate swings. |
| Availability of Hedging | More common derivatives markets for USD/EUR hedging. | Less developed, though some local currency futures/swaps exist in major EMs. |
If you’re calculating total returns, you need to account for both the bond’s yield and the exchange rate movement of the EM currency relative to your home currency. A simple approximation of an investment’s total return (R_total) can be expressed as:
$$ R_\text{total} = \bigl(1 + r_\text{bond}\bigr)\times \bigl(1 + r_\text{fx}\bigr) - 1 $$
Where:
If the local currency depreciates, it can significantly reduce (or even negate) your bond returns in your base currency—so that’s a big reason why some investors prefer USD- or EUR-denominated EM debt.
Emerging market governments and firms often exhibit higher credit risk. Sovereign credit analysis typically focuses on:
When analyzing corporate debt, you have to consider traditional credit metrics (e.g., leverage, coverage ratios), but also whether the government’s credit rating might put a ceiling on the corporate’s rating. If a country is approaching a crisis, it’s rare for a firm to maintain a much higher rating than its sovereign.
EMs may experience abrupt policy changes—like imposing capital controls or altering corporate tax rules—that can directly affect bondholders. Political transitions sometimes happen more abruptly compared to developed markets. I still remember the jolt the markets had when a certain EM country suddenly changed leadership a few years ago, and new policies spooked foreign investors practically overnight.
One hallmark of EM investing is that their central banks often have more limited tools to stabilize their currencies, or face big domestic political pressures that hamper monetary policy. Result: sharp moves in exchange rates, which can dominate your bond returns.
EM debt often becomes less liquid in times of global stress—the so-called “risk-off” environment. Foreign investors may rush to exit the market, local banks might not have enough capacity to absorb the selling, and you can see huge price swings. Bid-ask spreads widen, too. So if you think you might need to sell on short notice, you should keep an eye on these liquidity dynamics.
Below is a simplified illustration of how foreign investors might purchase local currency debt, expose themselves to FX risk, and then receive payments in that local currency.
flowchart LR
A["Investor in USD"] --> B["FX Conversion <br/> Hard Currency to EM Currency"]
B --> C["Local EM Bond Purchase"]
C --> D["Yield + Principal Repayment <br/> in EM Currency"]
D --> B
In reality, this process can get more complicated, especially if you layer on forward FX contracts, cross-currency swaps, or other hedging tools.
Sovereign bond analysis requires a top-down approach:
The IMF and World Bank often publish research on debt sustainability. Their frameworks can be a great resource if you’re analyzing a sovereign issuer, particularly if you’re uncertain about currency exposures or the size of the country’s import bills.
Don’t forget about capital controls. Some EM governments set restrictions on capital inflows, outflows, or both. These measures:
If a government is short on foreign currency reserves, they might delay or limit repatriation of capital, effectively trapping your proceeds in local currency for an extended period.
Managing FX exposure is a major part of investing in local currency EM bonds. You can try:
Of course, hedging introduces its own costs and complexities, often eating into yield advantages. But in cases of a severe currency drop, a well-thought-out hedge can provide a lifeline.
EM bond pricing can vary widely. Some markets use fewer transparent benchmarks. Index providers—like J.P. Morgan with their Emerging Market Bond Index (EMBI)—publish how they weight certain bonds, and many global Asset Managers track these indexes. Yet the same bond might trade at different prices across different venues, meaning you can see some price fragmentation, especially in onshore vs. offshore markets.
Let’s say you have two countries:
The choice between these markets depends on your portfolio’s risk appetite and how comfortable you are analyzing local conditions. Selling the bond from Country B could get tricky if the market starts to panic, even though the yield is tempting.
Emerging market debt remains an exciting corner of fixed income but can be quite challenging when global conditions turn sour. Always keep your eyes open for currency movements, political risk, and regulatory uncertainties. Maybe you can’t predict every twist and turn, but thorough credit analysis and an understanding of local markets go a long way.
From an exam standpoint, remember to:
These topics often come up in scenario-based exam questions: expect to see vignettes describing, for example, an EM sovereign, its macro environment, currency management strategy, or a corporate issuer tapping international markets. Be comfortable explaining how a disruption in currency markets or fresh capital controls might affect bond valuations.
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