Emerging Market Debt: Portfolio focus: Fringe benefits
As an asset class, emerging market debt (EMD) is generating a real buzz among asset managers and investors. It may take some time, but pension fund allocations are expected to rise, given the mismatch between current allocations to the emerging markets and their increasing economic importance. Insight Investment head of EMD, Colm McDonagh, says: “Less than 1% of global pension fund assets are in emerging markets; it should be significantly higher. Within 10 years, emerging market countries will have 50% of global GDP.”
Ashmore Investment Management head of research Jerome Booth describes interest in EMD as being “much, much larger than anything we’ve seen before, particularly in the US, where there is significant acceptance that it is a major strategic allocation, not just part of an alternatives allocation”.
The global financial crisis and the deficits of many developed countries have caused investors to re-think what constitutes a risk-free asset. The Greek sovereign debt crisis this year has exacerbated this and highlighted the strength of the emerging markets. BlackRock’s Dynamic Diversified Growth Portfolio has brought EMD into its investment universe in the last 12 months. Lead portfolio manager Adam Ryan says: “Emerging market equities offer a leveraged play on global growth, but EMD is more focused on domestic economic dynamics.”
EMD is increasingly denominated in local currencies which is another attraction as, arguably, emerging market currencies are undervalued. Lombard Odier head of fixed income and currencies, Stephane Monier, comments: “The average running yield on high-quality countries, such as Brazil, Russia, the Czech Republic, Hong Kong, Singapore and South Korea is roughly 6% and there is a potential appreciation of the currency of 30% over five years.”
However, he warned that this return will be lumpy, but adds: “The total return could easily be 12% with volatility between 5% and 8% over the next five years. That looks pretty good, especially when you take into account the average debt to GDP ratio for the developed countries is going to be around 110% in 2014 and around 35% for emerging market countries.”
Currency risk can be hedged, but Aberdeen Asset Management EMD portfolio manager Max Wolman comments: “We are seeing much more interest in local currency mandates. The local currency market is now three to four times bigger than the hard currency market.” Corporate credit is another growing area. Booth comments: “Dollar denominated investment grade is safer than US investment grade, with 130 basis points more return and one year more duration.”
Despite the growing attractions of emerging market debt, it currently occupies a relatively small part of pension fund portfolios, typically below 5%.
BNP Paribas Investment Partners emerging markets fixed income CIO Sergio Trigo Paz, described two types of pension fund client when it comes to EMD. He says: “One is a long standing investor in the asset class, but its allocation is a couple of basis points compared to their AUM and they are finding it very difficult to get the board approval to increase it, although everything points to EMD.” Here, fear of negative headlines can mean that job preservation over-rides the investment case for more EMD. The second type of client, Trigo Paz said, has no EMD investment experience but is keen to invest. “They are ready to invest billions of dollars with rating, duration constraints and a very high yield target that are not in line with the market, or the degree of liquidity available. In both cases, you need to do a lot of teaching and explaining.”
However, some pension funds are making EMD moves. Germany’s largest pension fund, Bayerische Versorgungskammer (BVK), has decided to invest another €200m in EMD. Finland’s Tapiola Mutual Pension Insurance Company has a 5% EMD allocation and its head of fixed income Petteri Vaarnanen comments: “As this asset class matures, we believe there will be more emphasis on EMD. We see that EMD offers some level of diversification for traditional EMU-based allocation and also that valuations are attractive.”
The Royal County of Berkshire County Pension Fund currently has a 3% allocation to EMD, and its pension fund manager Nick Greenwood said: “It is treated as part of our bond portfolio but as a separately defined mandate. We will probably review the allocation in the autumn with a view to increase the local currency allocation out of other bonds.”
However, there are limitations with the industry standard EMD indices as investment benchmarks. Lombard Odier constructs its own indices using fundamental factors, while Booth says: “We are active managers in liquid markets, which means we change the country allocation all the time.” Emmy Labovitch, Union Bancaire Privée (UBP) head of marketing for asset management, comments: “Emerging market benchmarks are not always very diversified or representative of what you can trade”. Insight’s McDonagh says: “The question becomes do you allocate to index, index plus or a total return strategy?” He points out that the latter approach can minimise exposure to countries which are out of favour.
As a consequence, manager freedom is a common feature of EMD mandates. Greenwood says Berkshire’s EMD mandate is one-third local currency and two-thirds external currency, but a third of the external portion can be held in local currency.
Similarly, Vaarnanen adds: “Our external managers have quite loose mandates. We don’t want them to strictly follow certain benchmarks, but rather give them the opportunity to express their views on the market.” And bfinance senior associate, research and development, Mathias Neidert comments: “We are now seeing EMD products and mandates with a benchmark that is a blend of hard and local currency, such as 70:30 or even 50:50.”
In terms of risk, as well as interest rate and currency risks, Schroders’ currencies product manager, Christopher Wyke, adds that political risk has not disappeared from all emerging markets and says: “Because a lot of bonds are held by foreign investors you could have sharp price swings if they suddenly withdraw.”
It is fair to say that many investors now see EMD as an asset class with the potential to diversify risk and boost returns. As a result, pension fund interest is growing and EMD looks like moving from the fringes of pension portfolios to the mainstream, as emerging market economies advance in maturity and sophistication.