Opportunities in emerging market debt
Since the onset of the global financial crisis in 2007-8, emerging markets have attracted more than their fair share of headlines as being the place to invest for significant long-term growth. As the development of emerging markets such as Brazil, China and India continues rapidly, investors seeking to capture this growth and improve the risk-return profile of their portfolios are increasingly looking beyond traditional developed market equities and bonds to a newer asset class that has delivered surprisingly attractive risk-adjusted returns: emerging markets 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 past 10 years locally denominated EMD has delivered average annual returns of 12.4 percent—almost double those generated by global bonds, and with half the volatility of emerging market equities over the same period (see Table 1 opposite).
We consider three questions on the asset class: (i) what is the longterm strategic case for investing in EMD?; (ii) what is the outlook ahead?; and (iii) how could an allocation benefit an investment portfolio as a whole? How captives can access the asset class in light of regulation such as Solvency II equivalence is also discussed.
What is the long-term opportunity for investing in EMD?
For investors looking to access emerging markets against today’s background of low yields from developed markets, the returns from various types of EMD—both in terms of absolute return and Sharpe Ratio (a reward:variability ratio)—have delivered compelling riskadjusted long-term performance versus a broad basket of investment assets. Combined with the rapid pace of development in EMD and currencies, this has led many investors to consider their first active allocation.
The emerging market universe encompasses more than 140 countries. Over the past few years the debt issued by emerging countries and, more recently, companies within these countries, has begun carving out a niche for itself as a strategic asset class. Initially investments were largely confined to the debt issued by emerging market governments in hard currency (in other words, denominated in US dollars or euros), known as ‘hard’ EMD. Here the yields earned by investors and any subsequent capital gains or losses are driven primarily by the ‘credit story’. More recently, however, investors have begun to recognise an attractive, complementary investment to hard currency-denominated government debt in the form of local currency EMD (denominated in the currency of the issuer).
About one third of the countries within the total emerging markets universe have investable local currency debt markets. One key advantage of investing in locally denominated EMD is that investors may access returns from two sources: bonds and currencies. Therefore, investors gain exposure to attractive local yield relative to developed debt markets, plus the potential for capital returns as the yields of individual emerging market countries compress to levels more typical of the developed world. In addition, there is the potential for return from currency appreciation as emerging markets travel the path from emergence to development.
Bonds and currencies tend to react differently to changes in the economic cycle. Local yields are mostly driven by local macro-economic factors such as inflation, monetary policy and demand and supply of government bonds; emerging market currencies are typically driven more by fundamental and flow factors, such as trade and portfolio flows. This provides investors with the benefit of two diverse sources of return within one strategy, and this duality is a factor in contributing to both attractive returns and the lower volatility of potential returns for investors. In the landmark year of 2008, for example, local bonds posted positive returns due to their favourable reaction to lower inflation, slower growth and central bank rate cuts, yet currencies struggled in the riskaverse environment.
There are additional attractions to local EMD in that it now has a higher average credit rating (BBB+) than hard EMD (BBB-) as countries in the local EMD index have better liquidity characteristics than their hard currency equivalents. This reflects the progress made by many emerging markets in reforming their local financial sectors in recent years, underpinned by strong banks, insurance companies and pension funds. The growth of institutional investment in emerging markets has produced a steady source of local demand and reduced dependence on volatile, external investment flows.
Over the past 10 years the issuance of local currency denominated EMD has been significant. In June 2006 total outstanding local EMD in the market was around US $500 billion, and is now worth around $1.6 trillion. This expansion has been largely driven by many new emerging markets issuing debt in local currency for the first time, as well as capital appreciation over the period. Meanwhile, the total assets managed against local EMD indices by stand-alone local EMD asset managers has reached $125 billion, though this still lags behind the $227 billion managed against US dollar denominated ‘hard’ EMD.
What is the outlook for EMD?
In recent years local EMD has delivered strong returns, but what does the future hold? We are strong believers that emerging markets are in an excellent position to outperform developed markets for several years to come. Fundamentally, we believe that emerging markets have significant potential for strong growth coming from a lower base than developed markets—at current growth rates, emerging markets are likely to constitute more than half of the world’s GDP in only 10 to 15 years’ time. As emerging markets join the global economy, we believe we will see them move their economies up the added-value chain from reliance on agriculture—such as is seen in frontier markets—to manufacturing in middle-tier emerging markets, and then on to services, such as seen in more developed markets.
Supporting this fundamental dynamic is a number of key accelerator themes. Included in these are the positive economic and social reforms adopted by emerging markets over the past decade; the favourable demographics of most emerging markets, where younger, cheaper labour forces can be competitive compared to the older populations of developed markets; the commodities story, where emerging markets are the largest owners of depleting stores of raw materials in a global economy that is ever resource-hungry; and the growing sophistication of emerging financial markets. These themes complement the already strong fundamental backdrop in which emerging economies are moving more and more in line with developed economies. This convergence is likely to generate attractive capital gains for both local bonds and currencies.
"The growth of institutional investment in emerging markets has produced a steady source of local demand and reduced dependence on volatile, external investment flows."
Emerging markets account for an increasingly large proportion of total global GDP and, as they increase in significance in the global arena, asset allocations are likely to change to reflect this. Furthermore, because US dollar weakness appears to be a requirement for addressing global imbalances, emerging market currencies are likely to be beneficiaries of such a move. We believe global investors who are now starting to recognise the attractive risk-return characteristics of the asset class are likely to allocate much more significant sums.
There are risks associated with investing in EMD. Similar to any emerging markets investment, the asset class may be affected as a consequence of a move towards a risk-averse environment. This may affect both bonds and currencies, causing the yield compression seen over recent years to reverse. However, while investment risks can be significant in an asset class like this, we believe that attractive returns are likely to be delivered against continued comparatively low volatility. The diversity of the asset class, and the high quality of the issuers underpinned by the fundamentals described above, underpin this belief.
Where does an allocation to EMD fit within an insurance portfolio?
For investors considering their allocation, finding a suitable EMD solution may take into account a number of factors including the investor’s specific requirements, risk profile, domicile and regulatory parameters. To summarise the main ways of accessing EMD as an asset class, solutions include local currency denominated or hard denominated sovereign debt; on the other hand, a blended approach where local and hard debt is combined in one investment strategy may better suit an investor’s requirements. Investors may also consider a pure EM currency approach or explore emerging markets corporate debt, a fast-growing area of the asset class. At the same time, an investor’s risk tolerance parameters or investment restrictions might require that only higher rated local EMD markets, such as investment grade-only markets, are part of the investable universe.
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 EMD may assist in diversifying the risk of an overall global fixed income portfolio.
EMD can act as an effective diversifier within the growth portion of an insurance fund’s portfolio, rather than the liabilities portion of a 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.
Investec Asset Management, founded 21 years ago in an emerging market—South Africa—now manages $99.4 billion 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 more than 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 investment opportunities within emerging markets.
The opinions stated are honestly held but are not guaranteed and should not be relied upon. Nothing in this article should be construed as investment advice.
Richard Garland is managing director at Investec Asset Management. He can be contacted at: email@example.com