The hunt for yield has left few stones unturned. Richard Garland addresses the opportunities inherent in emerging market debt.
In a world characterised by exceptionally low developed market interest rates where major government bond markets and cash now earn less than inflation, investors are increasingly looking beyond traditional developed market equities and bonds to an asset class that has delivered surprisingly attractive risk-adjusted returns: emerging markets debt. To put the returns generated by emerging market debt (EMD) into context, particularly in light of today’s background of low developed market yields, over the last 10 years locally denominated EMD has delivered average annual returns of 12.0 percent—almost double those generated by global bonds, and with half the volatility of emerging market equities over the same period.
There are three ways to invest in EMD, each with its own distinctive attractions for investors: hard currency sovereign bond issuance, local currency sovereign bond issuance and hard currency corporate debt issuance. A ‘blended’ EMD approach is built around these three components and enables investors to access an exceptionally wide universe of more than 70 countries and at least 350 corporate issuers. Together, they benefit from a wide spectrum of attributes as well as introducing diversification. This has helped the blended universe to achieve very strong risk-adjusted returns over the past 10 years.
But what is the long-term strategic case for investing in EMD: how would a blended approach to EMD generate returns, and how would an allocation to this asset class fit within a captive insurance company’s investment portfolio as a whole?
The long view
We are strong believers that emerging markets are in a good position to outperform developed markets for many years to come. Solid reforms, favourable demographics, a wealth of resources, and sound financial markets all complement the already robust fundamental backdrop where emerging economies are moving more and more in line with developed economies. The path to convergence fordeveloping markets will of course be rocky, as we have seen with the recent sell-off in EMD this summer on the back of concerns over US tapering. We believe though for those with a medium to long-term horizon, the benefits could be substantial.
"There are additional potential returns from active allocation between the different components of a blended EMD portfolio."
The emerging market universe is broad, encompassing over 140 countries, many undergoing recent positive structural reforms, which underpin an attractive return story. It is also a dynamic one. The list of investable countries regularly changes and expands as frontier markets begin to develop attractively-priced local debt markets, while more mature emerging markets migrate out of the universe as they become expensive and attain ‘developed market’ status. Emerging markets are growing faster than developed markets, a trend that has been apparent for many years and is likely to continue into the future. At current growth rates emerging markets should account for half of global gross domestic product (GDP) by 2025, while 56 percent of all new economic activity was already being created in emerging markets in 2010, according to the IMF.
For investors looking to access emerging markets opportunity and also against today’s background of low developed market yields, the various types of EMD both in terms of absolute return and Sharpe Ratio have delivered compelling risk-adjusted long-term performance versus a broad basket of investment assets. Combined with the rapid pace of development of EMD and currencies, this has led many investors to consider their first active allocation.
Hard currency (or dollar-denominated) emerging market bonds are typically issued by countries that are in the earlier stages of their development, when foreign investors are willing only to lend to them in dollars rather than in the country’s own local currency. These bonds give investors exposure to the improving credit dynamics which may be taking place within the country. As the issuers’ fiscal fundamentals improve and they are better able to generate foreign capital through exports, so their credit standing improves. This leads to a narrowing in the additional yield spread, which foreign investors demand over similar maturity, ‘risk-free’ bonds (typically US government debt).
Local currency EMD is typically only issued once a country has developed sufficiently to have a functional banking, insurance and pension industry along with a demand for local currency-denominated assets. As foreign investors’ confidence in the country builds, they become more willing to lend to the government, not in US dollars, but in the emerging market’s own local currency. This form of debt offers investors two sources of potential return: first from generally higher yields, which tend to fall with improving inflation dynamics; and second, from currencies, which tend to appreciate with stronger exports, higher foreign exchange reserves and relatively fast productivity gains.
Emerging market corporate debt, ie, bonds issued by corporates domiciled in emerging countries, gives investors exposure to the rapid growth in domestic consumer demand, which in turn leads to demand for resources, infrastructure, financial services and manufacturing.
As these corporates expand internationally, their requirement for international capital increases and so they issue bonds denominated in dollars. Through improving credit fundamentals corporate debt can generate returns for investors in much the same way as sovereign hard currency debt.
A blended approach
In our view, the benefits of taking a blended approach to investing in EMD are threefold. First, there is the potential for superior riskadjusted returns due to diversification. By combining asset classes, investors are able to achieve attractive returns, but with below-average volatility, while simultaneously reducing the overall correlation of their emerging market investment to their existing holdings of developed market assets. Second, there are additional potential returns from active allocation between the different components of a blended portfolio. The wide EMD universe available to active managers allows for significant alpha opportunities.
By actively managing allocations between local currency debt, hard currency debt and currencies, or indeed between corporate sectors, companies, bond issues and even sections of the local yield curve, portfolio managers could lessen the impact of negative economic shocks and increase exposure to positive fundamental developments. A portfolio manager who aims to exploit these different returns by adjusting the blended mix through time should, if skilful, be able to generate outperformance. Strong macroeconomic insight and a thorough understanding of valuation and market behavioural factors should be part of the top-down analysis.
Finally, a blended approach provides access to a wide range of countries from frontier to well-developed emerging markets. In addition to offering investors a wide exposure across countries and corporates, a blended approach also gives exposure to a number of divergent economic factors and cycles. Inflation, currency appreciation, fiscal dynamics, monetary policy and economic growth, to name but a few, are all drivers of returns for different asset classes in different countries, all of which are at different stages in their economic development.
Richard Garland is Americas client group head at Investec Asset Management. He can be contacted at: firstname.lastname@example.org
emerging market debts, Investec Asset Management