Emerging Markets Fixed Income: Not Just for the Yield Seekers

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  • 07 mins 02 secs
Could EM debt be attractive to investors above and beyond yield enhancement? Steve Cook, Co-head of EM Fixed Income, Head of EM Corporates, explores the reasons why so many portfolios remain materially underallocated to emerging market debt, and explains how the evolution of EM debt has created new opportunities for fixed income investors.


PineBridge Investments


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Why should fixed income investors consider an allocation to Emerging Markets Debt?
Fixed income investors have typically looked at emerging markets purely as a yield play. What investors should consider is the diversification benefits. It gives you access to the emerging market growth story. In many cases actually the asset classes are much less volatile than many people perceive. And also material components of the asset class, it’s much less treasury sensitive. So if you’re concerned with US rates backing up, then it actually gives you less sensitivity to treasuries.

How are EMs today different from 10 years ago?
Emerging markets are very different to where they were 10 years ago. There’s many different components of the asset class - and they are materially different from each other. We’ve had over 10 years of almost consistent growth within emerging markets, so many of the sovereign and corporations, their balance sheets are much stronger. In many cases the fixed exchange rates that were previously prevalent within emerging markets have now disbanded. So most of the currencies are freely floating, which enables many of these countries to naturally adjust to external factors. So it’s materially different.

Another major component in terms of being different is the investor basis, very much the growth of the local investor base and their demand for local currency assets, which has actually led to the overall growth of the local currency sovereign asset class and underlying that means that generally the volatility that is prevalent in many of these countries are much less because of that very strong domestic investor base. In terms of the sheer size of emerging markets now, 10 years ago emerging market GDP was approximately 20% of global GDP; it’s now 40% of global GDP. So it’s a material and increasingly important component of the overall financial markets.

What are the key debt markets in EM?
There are three key debt markets within emerging market fixed income. The first and the largest is the local currency sovereign market, which is around $2trn in terms of investable assets, but it’s much larger in terms of total market capitalisation. But the local currency market is the most important.
The second largest market is the EM corporate US dollar market, which is approximately $2trn in size, which makes it larger than the US high yield market. The third component of emerging market fixed income is the EM sovereign hard currency universe, which is around $1trn in size, even though it tends to get the most attention from financial journalists or market participants. It’s the traditional market, it’s the old Brady bond market, but it’s very much now effectively the smallest component of EM fixed income.

Who are the key investors in EM Debt?
It is a very broad-based investor base that is looking at emerging market fixed income - and also currently invested. The largest component of that is the regional, i.e. EM investors themselves. For example Asia is pretty dominated by the Asian investor base. Over 80% of all Asian assets are owned by Asian investors. The Middle East are very large buyers of their own domestic market and also their international bond market. So over 68% of the bonds within emerging markets are held by regional and EM-focused investors.

What does this mean for hot money flows?
Hot money risk we believe is much less because of this core component of underlying home biased focused investors. Therefore, if the international investor in a particular country or particular corporate issuer decided to repatriate their money, or take their money out of that particular asset class, typically, the home local investors will pick up that selling of those particular bonds or the particular country.

Are US investors structurally underweight EM debt?
US investors are structurally underweight EM debt. If we look again using the EM corporate as an example, EM corporates are 15% of the global credit market, and typically our evidence is that US investors have typically invested 2 to 3% in emerging market corporates, even though they typically constitute 10% of their benchmark. So we believe that the US investors are structurally underweight the asset class, and also are typically focused on the Latin American region. So they are missing out on the broader opportunity set.

Why not go passive?
The active versus passive argument in EM debt for me is very much one that it’s very difficult for a passive investor to replicate our asset class. Using the EM corporate market as an example, the JP Morgan Semi Broad Diversified benchmark has 620 issuers. It has 1,300 securities and 52 different countries. To try and replicate that as a passive investor is very difficult. Also to actually try and find a narrower index which effectively replicates the opportunity set in emerging market debt is very difficult. So whilst we believe that EM debt, ETFs will grow in importance, we don’t believe they’re meaningful at the moment because of that difficulty in terms of replicating the asset class.

Why consider PineBridge for EM Debt?
At PineBridge we believe we have one of the largest teams in the asset class. We are a very experienced team. We’ve been in the business since before 1998. So we’ve been very much investing through the various emerging market cycles, even back to the Tequila Crisis way back in the 1990s. So I think, as an investor in EM if you’ve been through the various cycles you’ve improved and enhanced your investment, you’ve learned a lot of lessons along the way, and also we’ve built a very experienced team through the various cycles.

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Last updated 6 March 2017.