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How to blend emerging market bonds
How do emerging market fixed income investors balance their allocation of assets among hard-currency sovereigns, local-currency sovereigns and corporate bonds?
Luc D’hooge 12 Dec 2018
Luc D’hooge
Luc D’hooge

Let us dispel a common misconception right now: that emerging markets fixed income is a single asset class. The reality is that in purchasing power parity (PPP) terms, emerging market countries now generate over half of the world's gross domestic product (GDP) making them the largest contributor to global economic growth. When the economies in your investable universe are making up an ever-greater share of the global economy, it's an area you cannot afford to be out of.

Therefore, the challenge is not one of "to invest or not to invest" in emerging market bonds, but one of how to find the optimal allocation blend between the three asset classes within emerging market fixed income:

- Hard-currency sovereigns

- Local-currency sovereigns

- Corporate bonds

By blending hard-currency, local-currency and corporate bonds in a portfolio, investors can achieve a diversified mix, while taking advantage of the inefficiencies present in emerging market fixed income that create both value mismatches and event-driven opportunities.

Emerging Market Hard-Currency Sovereigns. Probably the most used emerging market fixed income asset class. Historically, hard-currency sovereigns have generated elevated risk-adjusted returns and the handful of years when returns were negative were followed by a year of positive returns (see chart 1).

Chart 1. Returns for hard-currency emerging market debt 1994-2018

 

Defaults are rare in hard-currency sovereigns and when they do happen, recoveries tend to be elevated. It's also important to note that defaulting bonds can still provide substantial returns, as fearful investors often overreact to initial negative news, pushing prices down only for them to recover strongly once the dust settles.

Compared to emerging corporates, hard-currency sovereigns tend to have a higher duration making them more volatile. Because sovereign benchmarks contain more countries than corporates, the average rating is lower, but sovereigns give you exposure to countries that are not easily available in emerging market corporates.

Emerging Market Local-Currency Sovereigns: On the risk spectrum, compared to hard-currency sovereigns and corporates, local currency places highest as governments in difficulty can print money to avoid default, thus debasing their currency's value. However, local-currency debt can also provide the strongest returns. Sustained improvement in the issuer countries' economies drive revaluations and thus currency appreciation and improvements in credit quality. The added advantage of local-currency debt is its diversification benefit as it exhibits low correlations to other areas of fixed income (See chart 2).

 Chart 2

Source: Bloomberg, Vontobel Asset Management

The local-currency universe is represented by just a few benchmarks, which are not representative of the true diversity of the investments universe, as they contain only a relatively small number of countries and are skewed towards commodity producers. Therefore, with local-currency bonds, an active approach that goes beyond the benchmarks provides a larger opportunity set for investors to choose from.

Emerging Market Corporates. This may come as a surprise to some, but the emerging corporate universe is, in our view, the least risky and most diversified of the three asset classes. At nearly two trillion US dollars in size (hard currency) it is twice the size of US dollar denominated emerging sovereigns. Emerging corporates offer wider spreads than their developed market counterparts, but with considerably less leverage and lower duration. Investors who have the ability to evaluate the specifics of corporate issuers (including governance) can take advantage of event-driven opportunities to generate income uncorrelated with the broader market. By taking an active and bottom-up approach, investors can unlock the value inherent in emerging market corporate bonds, allowing a significant boost to portfolio yields and thus income.

Allocate actively

As emerging markets continue to take up a larger share of the global economy, it is inevitable that a rebalancing of allocations will occur. The prudent investor should approach their investment strategy not as a question of in or out, but rather as one of where and how much to allocate between hard-currency sovereigns, local-currency sovereigns, and corporates. After all, money left on the table does not deliver yield and carry; being in the market and optimizing your allocation does. This is why a blended approach to emerging market fixed income is the way forward to optimize returns for emerging market fixed income investors.

Luc D'hooge, head of emerging market bonds, Vontobel Asset Management

 

 

 

 

 

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