What is your approach to emerging market debt?

Bruus-Jan Willemsen
Blue Sky Group
Fixed income fund manager
• Assets: €12.5bn
• Fiduciary manager of several Dutch pension funds including that of KLM
• Participants are DB schemes but investment pools are open to all schemes - nine pension funds are participants in the Blue Sky Group investment pools
• Date established: the KLM pension fund in 1934, Blue Sky Group investment pools in 2002
• The funding level of the KLM pension funds varied between 123.3% and 130.9% at the end of Q1 10

Blue Sky Group has been investing in emerging market debt (EMD) since August 2002.
The decision to invest in EMD as a whole was driven by the desire to diversify the fixed income portfolio. With regard to value added by external managers, we expect an information ratio of 0.5 over the long term.

At present €487m of the EMD invested is denominated in US dollars, while €217m is invested in local currency debt, which corresponds to 7.2% and 3.6% of the total fixed income portfolio. Total EMD exposure makes up 10.8% of the entire fixed income portfolio.

While investments in EMD denominated in US dollar are generally quite widespread among Dutch pension funds, exposure to emerging market local currency bonds are less common. We chose to invest in those too due to their attractive risk/return profiles. Because we do not hedge the local currencies, we give the managers the opportunity to make bets on the currency as well as the government bond side.

Blue Sky Group also decided to follow a broader, fund-based strategy for the emerging markets part of its fixed income portfolio. Its EMD managers are allowed to invest in the entire EMD universe, as determined by the JP Morgan EMBI Global Diversified index. To a very limited extent they are allowed to invest outside the index. The index sets the duration and maturity requirements for the investments although the managers have a limited leeway to deviate. The Dutch regulator has not imposed any restrictions that would dent our current EMD investment plans.

We could see our strategic allocation towards EMD increase further in the future. At the moment we already have an overweight position in EMD US dollar and local currency.
As with all investments in the credit space though, we need to avoid the downside. While the upside on bonds is always very limited, you can lose 100% of your money in a downturn. We try to avoid this through a careful selection process of our managers. They need to have a unique and proven investment process in selecting and managing EMD and should have proven their ability to outperform the index within the EMD universe. For example, we do not want them to add high yield exposure or similar.

Constantin Echter
Bayerische Versorgungskammer (BVK)
Head of fixed income, structured products and spread investments
• Assets: €51.46bn
• BVK comprises 12 Versorgungswerke, the pension schemes responsible for professions regulated by a chamber, as well as two external Versorgungswerke
• Participants: 1.3m contributing members, 252,000 pensioners
• DB
• Date established: 1916

In the mid-2000s, BVK started to look at new sources of return in order to diversify its asset allocation. High yield emerging market debt was one of them and after a thorough analysis of the asset class, BVK issued its first EMD mandate in January 2005. Other alternative investments such as hedge funds and commodities followed.

At the moment, EMD investments amount to €500m. All of BVK’s EMD investments are undertaken by external managers via fund shares; it does not invest in EMD via segregated accounts because of the better handling and implementation of local currency bonds via funds. Three EMD managers are currently responsible for the portfolio but we are in the process of adding one or two additional ones because we want to invest another €200m in the coming months.

For us it is important that our EMD managers are not restricted when it comes to the selection of countries in their portfolio. Instead they should have the flexibility to be able to take advantage of opportunities in hard currency, local currency and corporate credit.
The manager should also have an absolute return approach and be flexible enough with regard to duration and instruments to be able to ask himself whether it is better to buy the currency directly or to invest in external debt or more specifically local debt. The EMD funds also have to have a UCITS III structure to enable us to invest in them.

In the manager selection process we partially work together with a consultant. However, the due diligence of managers as well as onsite visits are undertaken by BVK internally.
Our calculation figures for the strategic asset allocation are at 6% return at 10% volatility for EMD. So far we have been really pleased with the performance. As of today the fiscal position of emerging market government bonds looks on average a lot better than the one of industrialised nations. This means investors ought to take a good look at them individually and weight them much higher in their strategic asset allocation.

The only restriction the regulator imposes on German pension funds in terms of EMD is that they are not allowed to invest more than 3% in emerging market bonds graded below B-.

Erik Christiansen
Head of investment strategy

• Assets: €8.7bn
• Mandatory pension fund for France’s 4.6m civil servants
• DC
• Date established: January 2005
• Solvency ratio/funding level: 117% (Dec 2009)

Investments in EMD are restricted by ERAFP’s regulation, which only allows direct investments in OECD countries. So any additional EMD exposure would have to be undertaken through funds. But the amount would be quite limited because we are required to have at least 90% of our portfolio in euro denominated assets and are not allowed to hedge currency risks.

Our current asset allocation consists of 85% fixed income - 75% sovereign bonds and 10% non-sovereign bonds such as municipal, supranational and corporate bonds - and a little over 15% equities.

We do not have any plans to invest in EMD because the fund is still very young and the diversification process has only just started. We aim to add one or two new asset classes to the portfolio each year so we are likely to include it in the future.

We have already looked at the possibility of buying some direct central and eastern European countries’ (CEE) debt. Polish bonds look attractive to us, while the Baltic countries also are of interest. However, our plans to invest in these countries depend on the socially responsible investment (SRI) scores of these countries, some of which are not sufficient enough for our responsible investment framework today. But this may change with time.

Our SRI framework also excludes bonds issued by states with the death penalty, which limits the number of emerging markets we could invest in.

We look at the positive dynamics of a particular country, in other words if it had a bad starting point but is developing positively with regard to social, environmental and governance issues we may invest.

We do engage with some bond issuers. However, these tend to be local authorities because when it comes to municipal bonds we are a relatively big local establishment investor and hence have more influence on them than on companies. We have yet to engage with states or governments.

Other French funds are probably similar to us in that they invest mainly in euro denominated or OECD bonds for legislative reasons or because of a reluctance to hedge the currency risk.

As of today we buy only euro denominated bonds and despite the European debt crisis have held onto our southern European bonds, particularly in Italy. Some of the issuers are not in the euro-zone but still issue euro denominated bonds. We, for example, hold a little bit of Hungarian debt, which is denominated in euro.