Morgan Stanley IM: Emerging Markets Debt – Determinants of Sovereign Bond Quality and Returns

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• The findings demonstrate the determinant role that economic policy plays, in particular, which is analyzed alongside other macro variables related to the real economy, external sector and political orientation of the government.
• In our experience as EMD managers, we have seen that when we can identify countries implementing certain types of policies—i.e., those that enhance economic freedom—and that exhibit improvements for other country-level macro factors, then we stand to make capital gains for our investors.
• At the same time, if we can avoid countries implementing policies that lead to deteriorating economic freedom and with poor or worsening macro factors, then we believe we are better able to avoid a loss.
• We have also seen that economic policy matters most during times of economic duress and that by investing in countries with improving levels of economic freedom, we believe we are more likely to mitigate downside risk and earn better risk-adjusted returns through the economic cycle.

Introduction
The triumph of free markets following the collapse of command economies from 1989 to 1991 made clear which economic system produced superior socioeconomic outcomes—at least so far as the outcomes could be observed anecdotally.

By the 1990s, academicians began to empirically measure levels of economic freedom; the Fraser Institute’s Economic Freedom of the World Index, first published in 1996,¹ and the Heritage Foundation’s Index of Economic Freedom are perhaps the most well known.

Utilizing these tools, researchers started to investigate the relationship between economic policies and outcomes for GDP growth, poverty, child labor, life expectancy, literacy, potable water and a host of other development indicators.²

Not surprisingly, these studies moved beyond the anecdotal, showing that higher levels of economic freedom correlate positively to desirable socioeconomic outcomes.

Research into the relationship between the absolute level of economic freedom and investment outcomes yielded a different conclusion, however, showing no correlation.³

In this paper, we share proprietary research findings to show that what affects the investment returns of emerging markets debt (EMD), through changes in cash flow or the discount rate, are government policies that change the level of economic freedom, not the absolute level of economic freedom itself.

There is a paucity of research in this area. We believe our research helps to fill this gap, while also providing insight into our team’s approach to country research and investing in the EMD asset class.

¹ Gwartney, Lawson, and Block. Economic freedom of the world, 1975-1995. The Fraser Institute, 1996.
² Gwartney, Hall, and Lawson. Economic freedom of the world: 2021 annual report. The Fraser Institute, 2023.
³ Stocker. “Equity returns and economic freedom.” Cato Journal. 25 (2005): 583.

^{Risk Considerations
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and that the value of Portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this Portfolio. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. The risks of investing in emerging market countries are greater than the risks generally associated with investments in foreign developed countries. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. High yield securities (junk bonds) are lower rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. The use of leverage may increase volatility in the Portfolio. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates.}