The evolving landscape of emerging market private credit

Building upon our recent blog (“The ‘changing nature’ of DC investments”), our focus shifts to examining how private credit investments into emerging markets (EM) can be structured with a view to delivering resilient and attractive financial returns while aiming to promote the positive nature and social outcomes needed to close the United Nation Sustainable Development Goals (SDGs) funding gap.

Investing in EM private credit has historically been challenging for investors given relative higher risk of default and complexities around structuring transactions. Development finance institutions (DFIs), however, have come up with innovative ways of mitigating the inherent risk through insurance and guarantees. This has attracted a growing number and diversity of investors into the asset class. 

What are development finance institutions (DFIs)?

DFIs are specialised organisations, often backed by governments or multilateral entities, that focus on promoting economic growth and social development in EMs. They aim to address challenges such as poverty, lack of infrastructure development and climate change, while fostering private sector investment in regions that may otherwise be seen as too risky for conventional investors.

DFI guarantees reshaping EM private credit investment by reducing default risk and EM sovereign exposure, alongside enhancing credit ratings. This should, in our view, boost investor confidence, while granting developing nations access to more affordable debt and fostering economic growth.

These guarantees create what is commonly known as a wrapped bond or loan, which substitutes direct exposure to EM sovereign risk with the credit profile of the DFI. Guarantees come in various forms, generally covering the principal and interest in event of default. This approach not only elevates the creditworthiness of the transaction, but also lowers financing costs for the issuing country while potentially strengthening investor trust.

DFIs also frequently offer guarantees for loans targeting specific nature or social objectives. We see this approach as advancing regional development by backing projects that aim to deliver socioeconomic growth and enhance sustainability, overall contributing to narrowing the SDG investment gap.

In some situations, DFIs may opt to provide a partial guarantee for a portion of the loan issue, resulting in a portion of ‘naked’ EM exposure, more commonly known as an ‘unwrapped’ exposure. This unguaranteed approach typically yields a credit rating in line or slightly higher than the sovereign issuer while offering an attractive return profile. In certain cases, the spreads of the unwrapped portion can be up to 200bps wider than the wrapped portion.

The unwrapped portion benefits from a ‘halo effect’, as both the wrapped and unwrapped portions typically rank pari passu, preventing borrowers from selectively defaulting. Since DFIs are a key, low-cost funding source for many nations, sovereigns prioritise the repayment of DFI debt, offering implicit protection to the unwrapped portion. Investors in the unwrapped portion, therefore, may benefit from higher yields without assuming the full risk of being unsecured creditors to the sovereign.

DFIs are redefining the investment landscape in EM private credit, offering innovative solutions to tackle long-term challenges. Their guarantees provide essential stability, foster investor confidence, and offer developing nations access lower-cost debt, ultimately driving economic growth in these regions. By coupling financial guarantees with nature and social outcome objectives, DFIs further incentivise sustainable development, highlighting the critical role we believe they have in mobilising catalytic capital on a global scale.

For investors, we see this as presenting a compelling opportunity to potentially capitalise on EM exposure with reduced risk, while benefiting from an appealing spread pickup and further diversification.

It should be noted that diversification is no guarantee against a loss in a declining market.