But with many strategic bonds emphasising the importance of diversification in their portfolios, is there a place for emerging market debt or should it be avoided?
The performance of the average IA Global Emerging Market Bond fund in the five years to March 22 2016 has been a positive 12.5 per cent, compared with the IA Sterling Strategic Bond average return of 26.2 per cent, according to data from FE Analytics.
In the shorter term, emerging market debt has performed better, with the IA Global Emerging Market Bond sector delivering an average return of 8.9 per cent for the year to date, compared with the IA Sterling Strategic Bond average return of just 1.2 per cent.
Omar Saeed, manager of the L&G Dynamic Bond Trust, points out: “Since mid-2013, emerging market debt issuers [have been] experiencing fundamental and structural challenges linked to the continued commodity sell-off, strengthening of the US dollar and reversal of the [US] Fed policy. It is unsurprising the asset class has fallen out of favour for strategic bond investors.”
He notes that while these challenges are expected to persist over the next one to two years, the indiscriminate nature of the sell-off has created decent relative value opportunities.
“As a result, we have allocated towards a select number of short-dated EMD government debt and quasi-sovereign issuers. A running yield of approximately 4.5 per cent per annum can be realised, [but] suffice to say solid stock selection will be absolutely key,” he adds.
EXPERT VIEW - Emerging market debt |
Rodica Glavan, emerging market debt portfolio manager, Insight Investment, highlights the opportunities in a sometimes overlooked asset class: “These credits are under-researched, under-owned and unloved by mainstream investors. This creates mispricing and opportunity in spite of EM corporate debt’s status as a rapidly maturing asset class. The share of corporate finance via bond markets in EM has nearly doubled since the global financial crisis as banks have aimed to deleverage and shrink their loan books. “Headlines on emerging markets have been unremittingly bad. They have focused on the fear of a hard landing in China, the sharp decline in commodity prices and the perceived negative impact of an appreciating US dollar on debt sustainability. “[But] technical factors are also beginning to support EM corporate debt. The outflows from the asset class and poor investor sentiment have made it a difficult climate for new issuance. In the final quarter of 2015 there was a net supply of -$30bn. We expect this trend to continue this year. Our estimates are that $158bn will be returned to investors in 2016 in coupon and principal repayments. Bond buybacks are also becoming more popular due to currency volatility and could amount to $50bn over the course of the year.” |
Daniel McKernan, head of sterling investment grade credit at Standard Life Investments, notes the team behind the SLI Strategic Bond fund also has emerging market exposure, mainly for diversification purposes.
“There is a place for emerging market exposure in a strategic bond fund. Our timing for getting involved wasn’t perfect so, relative to, say, high yield, it had some underperformance last year. But this year it’s coming back quite strongly. And that’s part of the reason why we wanted some exposure because it does provide diversification and the correlations are relatively low compared to other credit markets.”
But Craig Veysey, manager of the Sanlam Strategic Investment Grade Bond fund, points out investors considering buying local currency emerging market debt have to make three key decisions: a government bond decision, a credit decision and a currency decision.
He explains: “Given the high correlation of emerging market bonds with US Treasury yields (and the US dollar), it is important to consider the sustainability of lower US interest rates and Treasury yields. Next, there is a credit decision on the ability and willingness of the emerging market government to service its debts. Then we must also consider the valuation of the emerging market currency versus the base currency of the investor. If we favour the bonds but not the currency, then we may decide to hedge the currency risk.”
As a result, he notes the team are cautious about investing in emerging market bonds, in light of the recent rally in prices and currencies.
“This ensures that the starting point is less attractive than previously versus some areas of the corporate bond market where we still see risk-adjusted value, such as subordinated financials,” says Mr Veysey.
“We may reconsider this strategic decision should yield and foreign exchange differentials move much more in favour of emerging market bonds. The underlying fundamental conditions are certainly a lot more benign for emerging markets, but also corporate credit, than a few months ago, when commodity prices were plunging and US rates were still expected to go higher.”
Gordon Harding, fixed interest investment director at M&G, agrees there are some positive factors, such as macro adjustment processes getting closer to an end, and downgrades and currency depreciations that have led to asset prices adjusting significantly.
But he warns: “Reforms still need to be restarted in many places and risks are still present in the asset class with ongoing low oil and commodity prices, the possibility of the US Fed hiking more aggressively than the market is expecting and China possibly hard landing. Idiosyncratic risks also remain elevated.
“However, there are more than 60 countries within emerging markets. The asset class presents some risks, but there are also some interesting opportunities.”
Nyree Stewart is features editor at Investment Adviser
