A shift is taking place in investor attitudes towards the $14 trillion emerging market debt sector, with its growth and maturation demanding that it be seriously considered a varied asset class in its own right, according to manager Neuberger Berman.
Rob Drijkoningen, co-head of Neuberger’s emerging markets debt team explains that investors historically considered emerging market debt to be “one call”—whether to invest or not. But its coming of age has prompted a shift in thinking, and a greater appreciation of EMD as a varied asset class in terms of characteristics and performance.
The key issue for investors looking to tap into EMD is deciding on asset allocation strategy within this space. For perspective on this, Drijkoningen has looked at the performance characteristics of two key EMD market segments—hard and local currency debt.
He explains that hard currency debt is issued by emerging market sovereign or corporate issuers, but denominated in US dollars, euro or yen. Local currency debt is made up of sovereign debt issued in local currencies.
LC debt provides generally higher yields and shorter duration, and therefore less interest rate risk than hard-currency debt, but it is also directly exposed to currency fluctuations. The HC debt universe includes more countries and a lower average debt rating than the LC debt universe.
Drijkoningen’s analysis reveals that overall, the long-term performance statistics for LC and HC are similar. According to the relevant indices, local bonds have provided a 10.6% average annual return over the past roughly 12 years, modestly outpacing the 9.8% return of HC sovereign debt, but with additional volatility (a 12.1% standard deviation versus HC sovereigns’ 9.2%).
Looking at the underlying reasons for the variation, Drijkoningen notes that spreads and FX returns are the most volatile components of HC and LC returns, respectively, and generally have been the largest contributors to total returns in each particular area.
“When looking at relative results, we found that the performance of sovereign spreads versus FX was the largest differentiating factor between the two segments, as local debt outperformed strongly when FX led spread return. As a result, we believe that having a view on spreads versus FX is a key component of the asset allocation decision between the hard and local currency debt markets.”
He adds: “It is clear that emerging market currencies have generally underperformed in recent years. Lower growth in emerging markets hurt currencies more than spreads, as the latter were supported by investors looking for higher yield; and currencies struggled as emerging market central banks lowered interest rates, which tended to help spread sectors. Although muted inflation pressures and monetary easing supported local yields and investment flows, the impact was not enough to offset currency underperformance.
Local currency favoured
“However, we think that local currency debt is now in a good position to outperform hard currency debt. Given the backdrop of potentially higher US Treasury yields and stronger growth, local bonds’ somewhat lower correlations to Treasuries, shorter duration and higher yields than HC should make them more resilient.
“We also do not think inflation will pressure local bonds, as our inflation expectations remain relatively low even after the recent depreciation of some emerging market currencies.”
These currencies should also be supported by stronger cyclical growth and potential inflows to EM equities benefiting from economic recovery. In contrast, HC spreads, which have been helped by the global “search for yield,” may suffer as higher Treasury yields prompt fewer investors to look to emerging markets for portfolio income.
From an absolute return perspective, Drijkoningen’s view on both HC and LC segments is generally positive. As for relative performance, he reckons that, for now at least, non-EM developments such as fallout from US budget negotiations and uncertainty around Federal Reserve tapering could keep EM currency volatility at elevated levels. At the same time the perception of somewhat diminished EM fundamentals could keep a lid on positive sentiment around their currencies.
As a result, Neuberger has a neutral view on near-term allocation between hard and local assets. Over time, however, it is likely to favour increasing exposure to LC debt based on improving growth tied to recovery in developed markets and further policy responses by EM countries in dealing with ongoing challenges.
Drijkoningen adds: “More broadly, we believe that such timely assessments of the segments within emerging debt markets, along with judicious shifts in portfolio allocations, can help investors capitalise on the varied opportunities that emerging markets debt may provide.”
You might also like to read Ashmore’s upbeat view on emerging markets fixed income