This distinct asset class continues to be a favoured area of fixed income with its high yields and value – it is still relatively cheap versus other global options. In addition to this, the emerging markets and developing economies have become increasingly important in the global economy.
They now account for more than 75% of global growth in output and consumption, almost double the share of just two decades ago, according to figures from the International Monetary Fund. On the downside, EM debt is perceived as quite risky by some asset managers and investors.
As a result some have become more defensive in light of recent gains and increasing political uncertainty, favouring shorter-duration bonds and adding dollar-denominated bonds.
Matt Murphy, institutional portfolio manager and vice president at Eaton Vance, says: “We believe the primary source of risk in EM debt is benchmark construction, because its country weightings frequently impose unintended risks and/or risks without sufficient upside potential. Asset allocation strategies, which rely on top-down, benchmark-constrained positions, share these characteristics.
“For example, dollar-dominated sovereign bonds have exposure to the US Treasury yield curve. Usually such exposure is unintended or undesirable, because it adds a developed market risk factor to the EM portfolio. Similarly the performance of a number of eastern European currencies is highly correlated with the euro – another developed market factor that is usually unwanted.
“The structure of EM benchmarks works to compound such risks, because they are concentrated in larger issuers, which helps reduce diversification, increase volatility and inject developed-market risk factors into the EM portfolio.
Murphy says: “We believe that the risk inherent in this asset class is best managed through an index-unconstrained approach based on country-level macroeconomic and political research, and stand-alone analysis of specific risk factors. EM debt offers an attractive risk/return profile in a strategy that is effective at isolating desirable risks while mitigating those that are not.”
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Looking ahead, there are several factors which could influence the asset class in 2018, including global economic growth, a rising US dollar, if the US Federal Reserve raises interest rates faster-than-expected, the rise of nationalism and geopolitical concerns.
Murphy says: “The geopolitical concerns that affect any broad asset class are generally going to also affect EM debt. The key difference is that emerging market local debt starts from an attractive valuation; no other asset class in the capital markets has this starting point.”
“What would adversely affect emerging market local debt would be if the Fed were to hike faster than the market expects.
“However, let’s say they hike four times but the market expects three, an additional 25 basis point isn’t going to be catastrophic for EM debt because it’s just the Fed moving a little faster than expected. This is in contrast to 2013 where the Fed just flat-out reversed course.
“Another thing to highlight here is that between 2004 and 2007 the Fed hiked 17 times and, in those three years, emerging market local debt was the best performing asset class relative to all other traditional fixed income,” says Murphy.
EM debt offers an expanding opportunity set with plenty of diversification opportunities. What’s more, the diversity of the asset class should mean more attendant alpha opportunities for investors, but the changing nature of the performance drivers make alpha generation less straightforward than it seems.
“It is relatively easy to invest in emerging market debt through portfolios that track a major benchmark, like the JPMorgan Emerging Market Bond Index Global (EMBIG) for hard currency debt, the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) (local currency debt), or the JPMorgan Corporate Emerging Market Bond Index (CEMBI).
“The challenge stems from the fact that while the benchmark-based strategies are common and straightforward approaches, they fall short of fully exploiting the potential of emerging-market debt, in our view. Going beyond the confines of benchmarks entails a greater level of expertise and commitment than most asset managers can provide, especially those principally involved in developed-market debt.
“So we would argue that the challenges of investing in emerging markets are not inherent in the asset class, but are a function of the asset manager’s capabilities,” says Murphy.
Matt Murphy presents the Eaton Vance Emerging Markets Local Income Fund, an actively managed product that takes an index-unconstrained approach to emerging market local currency debt.
The Fund has an investment universe of more than 100 countries and a team of 40+ professionals who focus on country-level analysis in conjunction with associated risk factors.
