SPONSORED CONTENT | The appetite for emerging market debt has increased globally, yet local institutional investors have been reluctant to take advantage of the asset class despite the offer of higher returns.
But with Australian government bonds now at a record low, super funds are starting to debate whether an allocation to the higher-yielding assets like Chinese debt is an obvious next step.
Stephen Nash, investment strategist at Vision Super Australia said at a recent PGIM-sponsored Investment Magazine roundtable that with the 10-year government bond yielding just 1.01 per cent, the country had reached a tipping point.
“We thought we were different to other markets,” he told attendees. “We thought we would always have 5 per cent cash rates, bond yields of 3 to 4 per cent and always be above US Treasury yields. We thought we would never have to consider other assets but that’s all changed and people will be forced to reconsider new opportunities.”
Allianz Australia’s chief investment officer, Anthony Michael, said key to investing in emerging market debt was understanding the underlying risks and expectations of volatility and returns. He said the debt strategies could be particularly beneficial in a late market cycle where returns from developed markets were muted.
“If you want to invest in something that presents opportunities for active management then emerging market has it in spades,” said Michael. He added that emerging market debt was less risky and generated higher returns than buying the equity market.
A shift in view
A challenge for asset owners is trying to identify where emerging market debt fits into their portfolio allocation, according to the attendees. They said the internal bandwidth and resources required made it a difficult asset class to invest in when their usual driver of returns is equities.
Allison Hill, director of investments, global multi-asset at QIC, said that while emerging debt was correlated with equities, it had some diversification benefits and opportunities to generate alpha within credit.
The QIC investment chief said super funds were starting to recognise that they need to evolve into that space. “More importantly, there are also opportunities from an investment universe that’s perhaps less scrutinised than some of the more mainstream markets,” she said, before adding that the funding of emerging market debt by QIC would be taken from equities and any change in risk would be balanced at a total portfolio level.
The sticking point
Asked where emerging market debt would sit in portfolios, participants were clear; in considering whether to allocate to emerging market debt they look at exposures across the whole portfolio.
“If you think about emerging markets as a beta, then where do you want to take that and where do you have your highest expected risk adjusted return,” said Hill. “If we’re going to have emerging market beta, where are we prepared to accept that volatility and where do we think we’re going to get the returns for that volatility?
Conexus Financial’s Alex Proimos asked asset owners what it would take for them to make the leap from equity to debt which had historically better realised returns.
As head of international content for local events, Proimos challenged participants on why they were so positive on equities, which have suffered prolonged periods of sharp drawdowns, versus debt which had performed steadily.
Ben Kilmartin, investment committee chair of Drummond Capital Partners, said they looked at allocations from an equity market equivalence perspective. “If emerging markets are volatile and present themselves as cheap, we should at least consider debt as an opportunity as long as it improves the chances of achieving total portfolio objectives,” he said.
Ross Pritchard, First State Super’s portfolio manager of credit income said while he was attracted to the idiosyncratic risks of emerging market debt and uncorrelated opportunities, they had limited time to understand this type of investment.
Prichard said he operated in the “goldilocks zone” of achieving enough return whilst still remaining defensive. He said while their credit strategies sit within a return-seeking portfolio, there were constraints around volatility and potential drawdown.
Michael Dennis, a senior analyst at AMP Capital’s multi asset group, said it all came down to timing when recommending a new asset class to an investment committee. “You want the ducks to line up,” he said. “Where are we in the cycle? Where are spreads and does an investment make sense?”
QIC’s Hill said while the current market conditions would continue for “a very long time” pressures were building with an economic slowdown in Europe, trade wars and other geopolitical risks looming on the horizon. “So, the question is, when do you want to take a step into what is a volatile and risky asset class?” she asked. “It’s definitely a consideration, it weighs on your mind.”
Edwin Lo, a senior portfolio manager at Christian Super, said noticed the amount of structural reform that had taken place in developing markets. “Compared to 10 to 15 years ago, there is more fiscal discipline in emerging markets than a lot of the developed countries, especially the European country peripherals,” he added.
More than one market
Mariusz Banasiak, principal and head of emerging markets local currency rates and FX at PGIM Fixed Income, said investors need to look at the asset class as a number of individual countries rather than just a sector as a whole. “That has been the biggest transformation in the asset class and the primary reason why there are considerable idiosyncratic alpha opportunities,” he said.
Banasiak also said the number of investible markets had grown over the last 20 to 30 years. “In the early nineties there were about 10 or so investable countries in the hard currency space and they were seen by investors as similar,” he said. So, when the tequila crisis hit Mexico in 1994, investors feared that Brazil and Argentina would suffer. There was huge contagion risk.”
Now, there are about 80 investable countries, all with different dynamics. “Many countries are mature investment grade quality,” said Banasiak. “There are also a lot that are immature and are below investment grade, and it’s that diversification that has reduced contagion risk considerably,” he said.
“When Argentina had a surprise election result in August of this year, the country’s bond prices fell 50 per cent. Spreads on other EM country bonds also widened. Ukraine bond spreads, for example, rose 60 bps but then narrowed again two days later when the market questioned how Ukraine would be affected by unrelated events in Argentina.
De-globalisation, lower real nominal growth, trade wars, and protectionism have not affected hard currency emerging market debt as much. He said local currency emerging market debt was highly cyclical and, as such, PGIM Fixed Income has preferred hard currency assets in their portfolios this year. The asset manager is also underweight emerging market currencies relative to indices.
“We believe most sovereigns are unlikely to default over the intermediate term, so investors will likely to get their coupons at the end of the day,” Banasiak said.
The rise of China’s bond market
As for China, Banasiak said the country was becoming a bigger part of fixed income benchmarks which could potentially take capital flows away from broader emerging markets.
China government bonds and policy bank bonds, for example, were included in the Bloomberg Barclays global aggregate bond index in April this year. As a result, investors benchmarked to the index can expect it to grow by about US$135 billion or more. So far, China has seen about US$49 billion of inflows into its fixed income market since April.
And next year, China will be included in the JPMorgan local EM GBI index with a 10 per cent index weight which is likely to result in $25 billion of inflows. The country will also be included in the FTSE Group, adding a further US$100 billion for index-weight investors.
“If all of that happens and there is no increase in the overall allocation to emerging market local fixed income by global investors, the countries that have current account deficits like South Africa, Turkey, Columbia, and Brazil are going to suffer because there will be less inflows into those countries,” warned Banasiak.” This is particularly problematic as those four countries have growth issues as well.”
Even so, the local bond and currency specialist said investors are not blindly buying Chinese debt.
“China fixed income actually looks very attractive relative to many other investment grade countries,” he said. “And the shape of the yield curve is attractive as well. As investors get comfortable with analysing China from a local perspective, they may be overweight versus the index.”
Overall, we hold a constructive outlook on EM debt. A “barbell” that emphasizes lower-quality, front-end sovereigns and higher-quality, back-end issues may just capture the upside alpha opportunities in a constructive environment and limit the downside in a volatile backdrop.