As global cash rates remain close to zero, Australian investors searching for yield beyond traditional fixed income should consider emerging market debt.

MFS International income portfolio manager Ward Brown said the debt asset class has grown to $US5.3 trillion, split evenly between high-currency sovereign debt and corporate debt and provided good correlations for Australian investors against US peers.

“When we typically think about adding yield to our portfolios, we like to think of it without adding volatility,’’ Brown told a panel discussion at Investment Magazine’s Fixed Income Private Credit Forum.

Two characteristics

“An asset that is going to help you has to have two characteristics, good risk-adjusted returns on a stand-alone basis, and local relations with other assets in the portfolio.

“Emerging market debt has both those characteristics for Australian investors, some of the correlative properties are quite unique for Australians looking for Australian dollar returns by using emerging market debt to enhance yield and reduce volatility.”

He said the Australian dollar was positively correlated with many emerging market currencies and acted as a natural hedge with Australian investors getting the same yield but less volatility than US investors.

Correlation of emerging market debt between local and hard currency debt with US investors was 0.8 per cent but for Australian investors was almost half at 0.44 per cent.

Enhancing risk returns

“It suggests that the Australian investor could enhance the risk-adjusted returns more by potentially blending the hard with local currency,’’ Brown said.

A look at 10-year volatility for local currency in US dollar terms was about 11.4 per cent, in Australian dollar terms it’s 7.7 per cent, showing a “significant decline in volatility”, he said.

To determine if a blend of hard and local currency emerging market debt would benefit Australian investors, MFS did a forward-looking return exercise with assumptions.

“We took the yields on the indices at the end of December and reduced them by 100 basis points for local currency due to exchange rate depreciation and 100 basis points for the hard currency due to default costs,’’ Brown said.

“We took the 10-year average volatility and correlations and in both cases the Sharpe ratios are quite high at 0.48 for hard currency and 0.38 with the local.”

To see if blending enhanced the outcome, Brown said the Sharpe ratios, which help investors understand the return of an investment compared to its risk, were highest in the middle.

“In the volatility column you can see around 50 per cent (hard and local currency) volatility of 6.7 is lower than 100 per cent local and hard currency. The conclusion there is likely to be a bit of benefit for Australian investors from blending local and hard currency,” he said.

He said emerging market debt had the characteristics to add yield, which could be made better by blending local and hard currency sleeves.

MFS has prepared a strategy paper which looks at more detail on the benefits of a 50/50 blend of emerging market debt, he said.


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