Continuing opportunities 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 market debt (EMD). To put the returns generated by 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 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 the highest risk-adjusted returns (0.65 percent) across all EMD strategies over the past 10 years.
This article will consider three questions: first, what is the long-term strategic case for investing in EMD; second, how would a blended approach to EMD generate returns; and finally, how would an allocation to this asset class fit within a captive insurance company’s investment portfolio as a whole?
What is the long-term strategic case for investing in EMD?
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 for developing markets will of course be rocky—particularly at the individual country level—but for those with a medium to long-term horizon we believe the benefits should be substantial.
The emerging market universe is broad, encompassing more than 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 frontiermarkets 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—in other words, in just 12 years’ time. Perhaps more important—from the perspective of a provider of capital—is that 56 percent of all new economic activity was already being created in emerging markets in 2010, according to statistics from the IMF.
For investors looking to access the emerging markets opportunity and also against today’s background of low developed market yields, the returns from 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 to lend to them only 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 issued only once a country has developed sufficiently to have functional banking, insurance and pension industries along with 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 returns: from generally higher yields, which tend to fall with improving inflation dynamics, and from currencies, which tend to appreciate with stronger exports, higher foreign exchange reserves and relatively fast productivity gains.
Emerging market corporate debt, bonds issued by corporates domiciled in emerging countries, give investors exposure to the rapidgrowth 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.
What does a blended approach to EMD offer investors?
In our view, the benefits of taking a blended approach to investing in EMD are three-fold. First, there is the potential for superior risk-adjusted 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.
"At current growth rates emerging markets should account for half of global gross domestic product (GDP) by 2025-- in other words, in just 12 years time."
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 will need to 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.
How would an allocation fit within a captive insurance company’s investment portfolio as a whole?
In the context of an overall fixed income portfolio, an allocation to EMD may be beneficial for investors looking to diversify away from developed market currencies and developed market spread products, particularly if concerns around developed market holdings are increasing given the potential for further ratings downgrades in these markets. Therefore an allocation to emerging markets debt may assist in diversifying the risk of their overall global fixed income portfolio.
Rather than within the liabilities portion of a portfolio, EMD can act as an effective diversifier within the growth portion of an insurance fund’s portfolio, in much the same way as allocations to alternative asset classes such as high-yield debt or infrastructure might be considered. Furthermore, as a result of Bermuda’s decision to opt for Solvency II equivalence, captive insurance funds which are restricted to investment in higher credit quality as part of their investment guidelines can invest solely in investment grade-rated local EMD. An actively managed approach will seek to identify the best opportunities across the investment universe at any given time, offering excellent opportunities for outperformance due to the large disparity of returns among countries.
Richard Garland is Americas client group head at Investec Asset Management. He can be contacted at: richard.garland@investecmail.com
Investec Asset Management, founded 22 years ago in an emerging market—South Africa—now manages more than $105 billion of assets for its global client base. Our emerging markets perspective is leveraged across all our investment capabilities, with more than half our total assets under management invested across emerging markets. We have over 75 investment professionals covering more than 60 emerging countries across our equity and fixed income teams, and a diverse platform covering specialist and core strategies. In the area of EMD, our dedicated specialist investment team covers local, hard and corporate EMD strategies. The result is a comprehensive range of liquid and less liquid, global and regional solutions tailored to accessing the broad and evolving opportunity set within emerging markets.
