Emerging market debt – a new frontier

From

Rodney Sebire

One of the key implications of COVID has been the growth in government debt issuance globally and the coordinated quantitative easing programs across central banks.  As government bond yields across the globe continue to grind lower (despite a recent uptick), the ‘search for yield’ thematic has accelerated, as advisers seek more innovative ways to generate attractive returns from the defensive component of client portfolios.

Emerging market debt (EMD) is one of the few asset classes that continues to offer attractive real yields; providing advisers with the opportunity to diversify away from highly synchronised G10 bond markets.  The current level of real yields in EMD are significantly higher compared to developed markets, with the following chart comparing the current levels and the median and historical ranges.

With higher real yields, we’ve observed a greater propensity for traditional International Fixed Interest (IFI) managers to invest in EMD, both as a source of extra yield and portfolio diversification. With approximately 25% of the bonds in the Bloomberg Barclays Global Aggregate Index trading with negative yields, the relative valuation of EMD is compelling and we expect more managers to allocate to the sector over time.

Additionally, the number of specialist EMD strategies available in the wholesale market continues to increase as advisers become more comfortable with the asset class and fund managers seek to meet this demand. Let’s look at EMD in more detail and some of the key considerations for including in client portfolios.

Background

EMD refers to debt or bonds issued by those countries whose economies are considered as developing or emerging, typically including countries from Eastern Europe, Africa, Latin America, Russia, the Middle East and Asia (excluding Japan). There is no universal definition of ‘emerging’ given a large percentage of sovereign issuers are rated investment grade and above.

Accessing the EMD sector can be achieved in multiple ways including via local debt (i.e. issued in the currency of the country), hard currency debt – that is, debt issued primarily in US dollars and/or Euros, or corporate debt. Here’s a brief overview of each.

EMD markets behave similarly to developed bond markets, in that central banks employ monetary policy and use interest rates and fiscal policy as the primary tools to modulate economic growth and ultimately inflation. Akin to analysing a corporate balance sheet, emerging market countries exhibit a range of qualitative attributes and financial balance sheet metrics that enable fund managers to perform detailed due diligence and ultimately attach a risk premium to each bond.

Incorporating EMD in Portfolios

EMD can be accessed as part of a broader IFI strategy or via specialist funds that invest directly in the sector.  In terms of the former, this could be via an IFI – unconstrained manager that specialises in relative value decisions between developed versus emerging markets.

One of the key benefits of accessing EMD via specialist funds, is the low correlation to traditional equity and bond markets and ability to dampen volatility during risk-off environments. Moreover, the asset class is driven by a range of idiosyncratic return factors, such as EM inflation, sovereign fiscal policies, debt levels versus GDP, commodity prices, US dollar movements and overall financial stability.

In terms of the risk/return characteristics of EMD LC and HC, the following table compares EMD LC with HC.

As detailed earlier, EMD LC returns include both a bond (capital gains and coupon) and currency component, with the proportional contribution of each changing through the cycle. EM currency valuations or real exchange rates can offer significant valuation upside, providing a significant buffer to returns. The following chart decomposes the relative monthly contributions from bonds and currencies and the rolling two-year correlation between each return stream for the period 1 Jan 2003 to 31 Jan 2021.

The currency component of EMD is sensitive to a range of factors, most notably the global appetite for risk and spillover effects from developments in the US. Therefore, EMD LC can behave like to a short US dollar position (i.e. outperform (underperform) when the US dollar depreciates (appreciates)), in that the asset class tends to underperform when demand for the US dollar is strong.

From an Australian investor’s perspective, investing in EMD LC (in AUD) captures the diversification benefit derived from investing via Australian dollars – similar to investing in global equities on an unhedged basis. As a commodity currency, the Australian dollar depreciates during ‘risk-off’ events (i.e. positively correlates with EM currencies), resulting in the value of EM Bonds appreciating – when restated back in AUD terms. This tends to reduce the drawdown sensitivity and overall volatility of the EMD LC asset class.

The low yield paradigm presents a range of challenges for advisers in terms of building IFI portfolios that generate attractive income streams and provide diversification to growth asset classes. EMD is an asset class that continues to grow in popularity, offering higher real yields and diversification away from heavily managed, developed bond markets.

For Australian investors, EMD LC (in AUD) tends to offer the most attractive risk-adjusted returns and constrained drawdowns, while EMD HC offers higher returns, but with more credit risk and sensitivity to traditional asset classes. Alternatively, EMD can be accessed by specialist Unconstrained (or Multi-Sector credit funds) managers, who are adept at selecting the most attractive EM issuers and the optimal points in the cycle to invest.

By Rodney Sebire, Head of Alternatives and Global Fixed Income Research

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