How Blending EM Debt can Generate Capital Gains in Fixed Income

In a Citywire roundtable debate, four experts looked at how the changing global economic landscape could present attractive opportunities in the varied and historically underappreciated sector of emerging market debt.

• Yoram Lustig, Head of Multi-asset Solutions for Europe, the Middle East, Africa and Latin America, T. Rowe Price
• Roman Mayer, Global Head of fund advisory, UBP
• Bart van de Ven, advisor and fund selector, Accuro Wealth Advisors
• Ulrich Voss, Head of capital markets, Tresono Family Office

With central bankers slashing interest rates to the bone to combat the global Covid-19-induced recession, the higher yields on emerging market (EM) debt represent an increasingly attractive proposition to investors. Even before the pandemic, interest rates and bond yields had fallen into negative territory in many countries – at one point in 2019, an astounding US$17tn of global bonds traded at negative yields. EM debt may come with greater risks, but investors are increasingly turning to it in the search for income.

As Yoram Lustig, head of the multi-asset solutions team for Europe, the Middle East, Africa and Latin America at T. Rowe Price pointed out, the predicted return¹ for EM debt for the next five years is 3.9%. In comparison, it’s just 1.9% for the global aggregate.

‘This is going to be especially important in an environment with higher beta. Passive returns are likely to be less than they were in the previous decade,’ he said. ‘So those extra two percentage points are going to be meaningful.’

As well as the potential for superior growth and income, one of the main reasons investors turn to EM debt is as a diversifier, with the potential to broaden a portfolio by diversifying against different countries, currencies, industries, yield curves and credit ratings. Some consider it a better option than EM shares, as EM debt tends to offer low correlation with developed market stocks and bonds, cushioning against volatility when markets underperform.

Lustig is a particular proponent of investing in EM corporate debt, a market that is now larger than the US high yield market or EM sovereigns, with US$2tn in issuance across 50 countries. ‘I think this is one of my favourite asset classes because if you look at the yield of the EM corporate bond index, it’s about 4.5% at the moment and the duration is about five and a half years,’ he said. ‘So it’s one of the asset classes with the best ratio of yield to duration, which means that it can perform both in an environment when rates are going up – or at least outperform other fixed income asset classes because it has much shorter duration than most other fixed income asset classes – and you have the yield pick-up. Importantly, it has historically performed well in both rising and falling interest rate environments, and I think that makes it very attractive.’

Although the sector is growing quickly, many investors remain cautious about allocating to some emerging markets, such as South American countries, due to perceived weaker institutions, policies and higher economic volatility. ‘Why should I invest in a country like Argentina that’s had nine defaults since becoming independent 200 years ago,’ asked Bart van de Ven, advisor and fund selector at Accuro Wealth Advice in Antwerp, Belgium. ‘I don’t see the need.’

While the others agreed about the importance of being selective, especially when investing in sovereigns, quasi-sovereigns and local currency, they are bullish about the progress EM debt has made as an asset class in recent years. Roman Mayer, who oversees allocations made by private clients to investment funds at UBP private bank in Zürich said that investing in emerging markets, particularly in Asia, is no longer something to be feared.

‘I’m coming from the point of view that it is a developed asset class,’ he said. ‘I think many clients are afraid of allocating to emerging market debt because they fear higher defaults. But when I look at the progress emerging market debt has made, we have now liquid markets, deeper markets, heterogeneous asset classes, and these companies or countries are managed better than they used to be run in the past. We have governance, oversight and regulation. This doesn’t bar us from defaults or from fraud, but if you have the right manager, the right solution and if you have a well-articulated process and philosophy, I think you can achieve decent diversification and also pick-up if you allocate to fixed interest.’

For investors unsure about which specific area to back within the realm of EM debt, Lustig points out that one option is to take an unconstrained approach and go with a blended exposure to the asset class. ‘My favourite approach for emerging markets is to blend,’ he said. ‘So, to blend hard currency sovereigns, local currency and corporates; then you have the full range of emerging market debt investments in your portfolio. That is the opportunity we try to take for many of our clients.’

Given the current global trends, Lustig predicts that, over the coming years, emerging markets could offer the same opportunities that were on offer in developed markets two decades ago. ‘Emerging markets in some ways are like going back in a time machine,’ he said. ‘If we have falling rates in emerging markets, we may have the boost that we got in developed markets over the last 20 years. So, there is still an opportunity to make capital gains in fixed income. Where else, these days, do you get the potential for that?’

Key Risks

Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates which may affect the value of an investment. Returns can be more volatile than other, more developed, markets due to changes in market, political and economic conditions. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default which may affect the value of an investment.