At a time of increasing risk and diminishing returns from traditional government bond investments, a growing number of large investors are beginning to cast their eyes toward emerging markets as a way to broaden their fixed-income portfolios.
Paul O’Brien, head of fixed-income strategy at The Abu Dhabi Investment Authority (ADIA), considered by many to be the world’s biggest sovereign wealth fund, points to a concentration of a so-called safe assets in a small number of large fixed-income markets as raising difficult questions for investors.
“To get a large, liquid bond portfolio you are really now limited to a small number of countries with fairly expensive securities,” says O’Brien. “It may be fine for now, but it could ultimately challenge the diversification role of fixed income.”
The fund uses fixed income for its diversification, store of value, liquidity and return characteristics, according to O’Brien.
The drive to diversify fixed-income portfolios has seen big investors look beyond the record low yields on offer in some developed-market-debt securities to take advantage of the long-term growth outlook and strong fiscal position of emerging markets countries.
Norway’s sovereign wealth fund has made a high profile pivot across its portfolio to emerging markets. As part of this push, up to 7 per cent of its overall portfolio will be dedicated to emerging markets debt.
While declining to comment directly on the investment strategy and holdings of ADIA, O’Brien says there was a need to balance the requirements of liquidity with the need to preserve capital in real terms.
Broadening the basket
JP Morgan estimates that emerging markets public debt now tops $7.3 trillion, more than tripling in size since 2000. Emerging markets debt denominated in local currency is put at $5.9 trillion, while corporate debt is about $1 trillion. By comparison, the US bond market exceeds $35 trillion.
O’Brien indicates the negative real yields on offer to investors in developed market bonds – such as 10-year US treasuries or similar UK gilts – as a driver for long-term focused investors to look to broaden their basket of bonds over time.
“It is making the decision a lot more interesting because the securities you look to for overnight liquidity are not necessarily the securities that will give you the best comfort in terms of the long-term preservation of capital or purchasing power.”
“It does lead one to thinking about a broader menu of countries in your portfolio and the possible trade-off between the need for capital preservation versus the need for overnight liquidity.”
Capitalise on evolving opportunities
Diversification is a key driver for large institutional investors who are looking to build out exposures to emerging markets fixed income, according to Mike Conelius, the Baltimore-based portfolio manager of T.Rowe Price’s emerging-markets bond strategy.
A 23-year veteran of the emerging-markets-debt landscape, Conelius says that funds are increasingly looking to gain exposures that capture the broad spectrum of the emerging markets universe.
This encompasses a blend of so-called hard-currency or US-dollar-denominated, sovereign debt issued in local currency and US-dollar emerging markets corporate debt.
T. Rowe Price first launched a hard-currency sovereign-bond strategy in 1994, and has since diversified to launch a local currency-focused fund and last year a dedicated corporate-bond fund.
Conelius says investors are increasingly demanding a one-stop shop where they can gain exposure through either pooled products or a tailored special account to local, hard and corporate bonds.
“We encourage the investor to allow us to use the whole opportunity set as much as possible, along with ensuring appropriate risk guidelines that place a limit country or sector exposure, but having broad flexibility is key because this environment is ever-changing,” Conelius says.
“So, the ideal mandate allows us to capitalise on the evolving opportunities.”
Conelius notes the importance of an emerging-markets manager keeping a close eye on the relative value of various debt opportunities both between countries and also within countries where hard, local or corporate debt may vary in attractiveness.
Francois Otieno, senior fixed-income consultant at Hewitt EnnisKnupp’s Chicago office, says the asset consultant is advising clients take a diversified approach that is reflective of the opportunity set as well as where it is headed.
“For entry into the asset class, we recommend 50 per cent local, 40 per cent hard and 10 per cent corporate, but this might vary depending on a client’s specific circumstance and this isn’t a hard-and-fast rule but a general guide,” Otieno says.
While foreign investors entering into the market have in the past typically made a first foray into hard-currency debt instruments, fixed-income analysts have noted this segment of emerging markets debt has changed rapidly in recent years.
The hard-currency debt market is shrinking relative to the growing market for debt of countries issuing in their local currencies.
These countries, being able to issue debt in their own currency, typically have stronger underlying economic fundamentals, which improves the credit quality of the local index. Meanwhile, the hard-currency basket has seen diminishing quality as smaller emerging countries such as Ghana and Gabon have recently joined the index.
Conelius says that the increasing allocations to emerging markets debt has also led to very strong technical environment for the hard-currency market, with spreads over treasuries narrowing to as little as 200 basis points for countries such as Brazil.
Investors, according to Conelius, have looked to local-currency debt to improve yield, and are increasingly looking to corporate debt.
“In hard currency we are finding individual countries of value and for other countries we just move into their local or corporate market.”
Maintaining a flexible approach is leading to a burgeoning trend for investors to award open mandates to emerging-markets-debt managers who can achieve absolute return-style objectives.
Advocating this approach is asset consultant Cambridge, with Singapore-based managing director Aaron Costello saying that taking an unconstrained approach with an experienced manager can not only lead to better returns but a more holistic approach to risk control.
“We are advocating investors adopt an “open mandate” approach to emerging markets debt (EMD), whereby active managers allocate across EMD debt and currency exposures,” he says.
“Rather than investors seeking to allocate across the spectrum, allow managers to make the relative valuation decisions and risk control to create a basket of EMD with attractive risk-return characteristics.”