Emerging Markets Debt
Gain access to a growing and diversified asset class
Since the start of the new millennium, emerging markets have entered a period of catch up with the developed world. Their debt markets have also grown exponentially. Local capital markets have developed in order to address increasing funding needs, while investors were attracted in their general search for yield.
- Emerging countries have entered a period of catch-up to the developed world
- Strategic re-allocations from developed to emerging markets benefit the development of emerging market debt
- From an asset allocation perspective, emerging market bonds provide important diversification benefits to fixed income portfolios
- With its long-standing and successful track record, NN Investment Partners is the ideal partner to manage emerging market debt
Five questions about Emerging Markets Debt
Emerging markets: catching up with the developed world
Global macroeconomic shifts that accelerated in the new millennium have lifted emerging market economies out of the endemic boom-bust cycles that characterised the 1980s and 1990s. Their economic growth rates have increased and since 2000, the growth differential between emerging and developed economies has been in favour of the emerging economies.
Emerging market real GDP growth structurally outpaces developed market growth
Source: IMF World Economic Outlook (April 2016)
In general, the growth differential between emerging and developed economies is a result of catch-up. A mix of factors, such as higher productivity growth and favourable demographics, has enhanced catch-up since the start of the new millennium. For example, productivity growth is structurally higher in emerging economies. Higher productivity potential has attracted capital from the developed world in the form of foreign direct investments, which support development and has helped lift the capital share of emerging economies relative to developed ones.
Emerging markets’ share of global GDP is growing steadily
Source: IMF World Economic Outlook (April 2016)
Origin of emerging market debt instruments
Emerging market debt instruments have evolved impressively as an asset class over the past decades. Markets for investable emerging market debt instruments trace their origins to the debt crises of the 1980s. A number of mainly Latin American countries were unable to service their (bank) debts which resulted in the Brady debt restructuring plan, named after US Treasury Secretary Thomas Brady. Non-bank institutional investors entered the emerging debt market after the Brady plan was implemented (early 1990s) and after it had proven its efficiency (by the mid-1990s). This was also the period when countries that had restructured their debt were able to return to international capital markets. Since the 1990s, emerging market policymakers have moved a long way towards increasing their country’s creditworthiness. Initially, after the so-called Tequila Crisis of 1994-1995 and the Asian Crisis of 1997-1998, policy discipline was imposed by capital markets and the International Monetary Fund. By now though, more orthodox macro-economic policies have been internalized by most emerging country governments, regardless of political orientation. Important achievements are, for example, the reduction in external debt levels, the liberalization of fixed exchange rate regimes and the adoption of inflation targeting as a pillar of monetary policy decision making.
Strategic re-allocation of assets by global investors will benefit EMD
Accelerated economic growth and wealth creation, the convergence of emerging and developed capital markets, credible growth policies in emerging countries and institution building efforts have all enhanced the status of emerging market debt as an asset class. We expect that strategic re-allocation from investment instruments in developed markets to emerging market debt investment instruments will increase in the medium to longer term. Home bias and regulatory restrictions have contributed to a situation in which developed world institutional investors are structurally under-allocated to emerging market fixed income. Increasingly, the importance of emerging markets – in both economic and capital market terms – has become too great to ignore. We expect to see an adjustment of these allocation imbalances as strategic flows direct themselves to the under-owned EMD sub-asset classes.
EM debt markets have been growing strongly
Outstanding EMD stock has grown at a fast pace since 2002. On the demand side, the general search for yield resulted in strategic allocations from foreign investors. The domestic institutional investor community also increased its demand for a broader range of investment opportunities in their domestic currencies. Sub-asset classes such as domestic debt and currencies and hard currency corporate debt have gained popularity and have started to attract a dedicated investor base within the broader emerging market debt universe. Local debt markets have evolved with the introduction of a variety of instruments, with the removal of legal and regulatory impediments to the free flow of capital, and with the general lengthening of yield curves. Over the past fifteen years, domestic debt (debt denominated in the local currency of the sovereign or corporate issuer), and corporate hard currency debt, in particular, have overtaken hard currency sovereign debt.
Domestic debt markets have been growing exponentially
Source: BIS, Bank of America Merrill Lynch (as of end 2014)
Sub-asset classes within emerging markets debt
We distinguish five sub-asset classes in the EMD asset class on the basis of their exposures to different sets of risk premiums and currency denomination. Hard currency (HC) debt is debt issued by an emerging market-domiciled sovereign or corporate issuer but denominated in US dollar, euro or yen. Local currency (LC) debt is debt issued by an emerging market-domiciled sovereign or corporate issuer and denominated in the domestic (or local) currency of the country of issue. The product range can differ in each market.
Hard Currency Sovereign Debt
External or HC sovereign debt is the most mature sub-asset class and offers investors exposure to emerging market credit risk and developed world interest rate risk. NN IP has managed hard currency sovereign debt portfolios since 1993. Our dedicated fund is NN (L) Emerging Markets Debt (Hard Currency).
Hard Currency Frontier Market Sovereign Debt
Frontier economies are typically at the early stage of development and are expected to grow faster than the emerging and developed countries. Frontier market debt is a relatively small but fast growing segment in EMD. Frontier markets have a non-investment grade credit rating and corresponding higher yield level. NN IP has a dedicated frontier market debt fund since 2013: NN (L) Frontier Markets Debt (Hard Currency).
Hard Currency Corporate Debt
External or HC corporate debt offers investors exposure to emerging markets credit and corporate risk along with developed world interest rate risk. NN IP has managed hard currency corporate debt since 2003 and launched a dedicated fund in 2011: NN (L) Emerging Markets Corporate Debt.
Local Currency Debt
Domestic or LC debt (government and corporate) is the largest sub-asset class. In essence, domestic debt is a combination of local bond and local currency exposures. NN IP’s local bond strategy offers investors local currency denominated government debt exposure and invests mainly in debt instruments with a remaining life of more than one year. NN IP has managed local currency debt since 2007 and launched a dedicated fund in 2010: NN (L) Emerging Markets Debt (Local Bond).
Local Currency Money Markets
Emerging foreign exchange (FX) or LC money market is the most liquid sub-asset class and offers investors local currency denominated money market/exchange rate exposure. NN IP’s local currency strategy invests mainly in debt instruments with a remaining life of less than one year. NN IP has managed local currency money markets since 1998 and launched a dedicated fund in 2000: NN (L) Emerging Markets Debt (Local Currency). In 2011 NN IP launched NN (L) Emerging Markets Debt Opportunities. This strategy invests across the full range of EMD sub-asset classes and instruments, resulting in exposure to hard and local currency denominated sovereign, quasi-sovereign and corporate debt, and emerging market currencies. The combination of a strategic asset allocation and a tactical overlay forms a unique investment approach in the dedicated emerging market debt investor space.
Attractive yield pick-up versus developed market bond yields
Source: JP Morgan indices' yields; Bloomberg (as of May 2016)
Challenges and Opportunities in EMD
Our investment team and philosophy
NN Investment Partners has a long-standing and successful track record managing the full spectrum of emerging market debt. We have been at the forefront of dedicated investment product development and have professionally managed hard currency sovereign debt portfolios since 1993, local currency money markets since 1998, hard currency corporate debt since 2003 and local currency bonds since 2007. We have consistently generated attractive risk-adjusted returns for our clients. The investment process focuses on medium-term fundamentals in emerging markets, and puts an emphasis on diversification discipline. The process is seamlessly executed by a team of EMD experts across three regions. Alpha generation is attributable to our disciplined, consistent and well-structured investment process, which includes ESG criteria. Risk management and performance attribution systems are completely integrated and aligned in our investment decisions. Risk management ensures sufficient diversification and proper allocation of risk across alpha sources and controls beta and ex-ante tracking error. Performance attribution analysis helps us identify our investment decisions and provides useful feedback towards investment process improvements. We are a global multi-site team. With a presence in three major time zones, the team takes advantage of seamless access to local knowledge and market liquidity. At the same time, our experience and expertise allows us to place local views into a global context and extend the universe of alpha sources from local to cross-regional and global. Our activity across the regions provides unrivalled access to superior decision making and alpha capture across the entire EMD universe.
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