The investment case both for and against emerging markets is a familiar one. Intermediaries are well aware that clients with emerging market exposure are vulnerable to the risk of capital losses, but also stand to profit from access to some of the world’s high-growth economies.
Both equities and bonds in these markets have been touted as wire bets in 2019, but this is yet to translate into renewed investor appetite. In the 12 months to the end of March, retail investors put just £8m into the Investment Association’s Global Emerging Markets sector on a net basis.
Emerging market debt is more of a niche proposition than its equity equivalent: the IA Global Emerging Markets Bond sector had £8.4bn in assets at the end of March compared with £26bn in the equity grouping. The former also has much less in the way of assets than other fixed income sectors.
There are good reasons for this. Emerging market bonds are less high-octane than stocks in the same region, but do tend to be riskier than other forms of fixed income given the instability of some of the companies and countries issuing debt. Intermediaries need not look far for an emerging market crisis: last year both Turkey and Argentina saw their currencies tumble because of wider economic troubles.
Investors have certainly not given EMD their overwhelming support in recent times: in the year to the end of March, the Global Emerging Markets Bond sector suffered net retail outflows to the tune of £65m.
But the rewards of backing these bonds can be significant for courageous investors: EMD typically offers much higher yields than other fixed income instruments, and has outperformed other parts of that universe when it comes to total returns, too.
A look at IA sector performance illustrates this point. A typical fund in the IA Global Emerging Markets Bond sector has returned 19.5 per cent over three years, beating its IA Sterling Corporate Bond, High Yield, Strategic Bond and UK Gilts equivalents. Over five years, the EMD cohort also had a higher average return than each of those peer groups bar UK Gilts.
Getting picky
Attractive as the returns look on paper, the volatility of this asset class means performance can vary extensively across different funds and regions. Given the high levels of risk and reward involved, picking the products best positioned to navigate this investment universe is especially important.
Table 1 shows the IA Global Emerging Markets Bond funds that performed best over the past five years. It might not be immediately obvious what has driven their strong performance, but a closer look at the funds suggests many do share at least one important common trait. This relates to currency exposure.
Last year’s developments in Turkey and Argentina show that emerging market currencies can fluctuate significantly versus their peers in developed markets, thereby distorting investor returns. But fund managers can decide whether to buy EMD issued in the local currency, or choose those instruments issued in US dollars or another developed market currency.
Those funds taking the second route – or buying ‘hard-currency’ debt – have prospered in a time when the US dollar has strengthened and several emerging currencies have run into trouble.
Of the 13 funds in Table 1 that disclose their currency positioning, 12 have all or most of their exposure in the dollar or other developed currencies. The only one without an obvious hard-currency preference, Gam Multibond Emerging Markets Opportunities Bond, still has 48 per cent of its exposure in dollar debt.
Of the top five names by five-year performance, the first four have a substantial majority of exposure in hard currency. The fifth name, M&G Emerging Markets Bond, is the most exposed to local currencies out of these names, but still has around two-thirds of assets in hard-currency debt.
The winners
Currency preferences are not the only crossroad for EMD investors: they must also decide whether to focus on buying government bonds, corporate debt, or both. While there are plenty of different approaches on show in Table 1, it is a corporate bond fund that has come out top over five years.
BNY Mellon’s Emerging Markets Corporate Debt offering, managed by Colm McDonagh and Rodica Glavan, has returned £1,675 from a £1,000 lump sum. The vehicle appears well diversified, with exposure spread across 71 holdings and at least 20 different countries. However, this makes it difficult to judge which factors have driven outperformance over recent years.
On a shorter-term basis, the fund’s managers have cited Thailand, the United Arab Emirates, Indonesia and Columbia as regions that performed well. Performance has also benefited from a rally in high-yield debt, though an underweight position in Asian debt has hindered returns. The fund’s biggest sector positions are a 30.6 per cent weighting to financials and 17.8 per cent in oil and gas.
Unlike the top performers in some of our other investment analyses, the best fund over five years fails to dominate its sector over the other available timeframes. The BNY fund comes in fourth place over one year, and ninth on a three-year basis. Fidelity Emerging Market Debt comes out top over one year, with Pimco GIS Emerging Markets Corporate Bond delivering the biggest return over three years. The BNY fund launched in 2012, meaning it lacks a 10-year track record.
Discrete annual returns are a reminder of the volatility inherent in emerging market investing. Each of the portfolios in Table 1 returned a minimum of around 20 per cent in the year to April 30 2017, a period when emerging markets returned to form. But every fund in the top 20 made a loss in the following 12 months.
Other paths
The vehicle in second place over five years, Amundi Emerging Markets Bond, is similar to BNY Mellon’s offering in that it focuses mainly on corporate bonds. But even within the top five, it’s clear that this is not the only source of good returns.
The third name, Fidelity Emerging Market Debt, can invest in both sovereign and company debt, but the majority of its biggest 10 positions are in government bonds. The fourth and fifth funds, offered by Neuberger Berman and M&G, both have more exposure to government bonds than credit.
As such, there are plenty of ways to approach the emerging market space. But although the most successful managers can deliver outperformance through a variety of individual strategies, investors are likely to remain beholden to macroeconomic developments.
As BNY Mellon’s team notes: “External factors have continued to be the biggest drivers of emerging market performance.” These range from global growth dynamics to the Federal Reserve’s plans for interest rate moves, developments in the trade war between the US and China, and more general sentiment in markets.
When it comes to risk sentiment, investors still appear cautious in the wake of the sell-off that hit markets in the final quarter of 2018. Growth has slowed in a number of developed economies, with the recent stoking of trade war tensions doing nothing to help the situation. Investors may also fret about the substantial levels of debt some emerging market nations have built up. The Financial Times reported in May that public debt levels across emerging markets were nudging half of annual output for the first time, citing data from the Institute of International Finance. With emerging market countries paying average interest rates of 5 per cent on their foreign currency debt, and even more on local currency bonds, some may fear the burden is too much.
But there are also reasons for optimism. For one, emerging markets received a major respite earlier this year via the Fed’s decision to back away from its previous intentions to raise US interest rates further during 2019.
‘High’ yield
EMD investors may yet benefit from another trait investors are finding attractive: high yields in an asset class where the payout tends to be meagre. The BNY Mellon fund does not break out its own yield, but lists the “average coupon” as 6 per cent. The Amundi offering lists its yield as 6.84 per cent. These stand in stark contrast with bond markets in developed nations, where even some of the riskiest corporate debt now offers underwhelming yields after years of strong capital returns reduced future payouts.
Recent analysis by Money Management’s sister title Asset Allocator, an email newsletter for discretionary fund managers, shows that professional investors are getting better yields on EMD than the high-yield market.
An assessment of funds favoured by DFMs found that popular EMD names tended to pay out more than widely backed high-yield products. For example, both M&G Emerging Markets Bond and a local currency sovereign bond tracker offered by L&G yielded more than 6 per cent earlier this year.
Most of the popular high-yield strategies paid less than 4.5 per cent. Investors might be unlikely to buy racier bonds for yield alone, but it is a trait that may draw more interest to the EMD space.
In contrast with our own findings on funds’ performance, DFMs have tended to sit on the fence as far as currency is concerned. Asset Allocator analysis shows that wealth managers tend to back funds without an explicit currency bias. However, it is likely many portfolios are favouring hard currencies of their own accord. This includes those funds that can go anywhere in the EMD universe, such as M&G’s offering. Similarly, some fund names can be misleading. Barings EM Local Debt, for instance, uses a mixture of hard and soft currencies.
All of this variation will remind intermediaries that EMD is subject to many nuances, as well as broader factors beyond an individual government or company’s control. But as Table 1 shows, the high risks also come with big rewards.
