Time to boost allocations to emerging market debt?
Emerging markets debt has a solid risk/return profile and attractive valuations. Our research project with MIT Sloan supports the view that increasing allocations to EMD is a good idea.
Emerging markets debt (EMD) is a sizeable and growing asset class that is on the radar screen of many institutional investors. Given the increasing economic importance of emerging markets, EMD is likely to continue delivering attractive risk-adjusted returns in the medium-to-long term. We see good reasons to enter or increase exposure to EMD, in particular for investors who seek to improve their global fixed-income portfolios on a structural basis.
Risk-return of asset classes, 2003-2017
Source: JP Morgan, Bloomberg, Thomson Reuters Eikon, NN Investment Partners
The attraction of EMD stems from its relative value versus other fixed income asset classes. Its risk premium underpins its favourable historical risk/return profile, and is the result of a disconnect between the perceived risks and the actual risks based on underlying fundamentals.
Investors may have been overlooking opportunities in EMD. This might be because the asset class is underrepresented in major fixed-income indices, in terms of the relative importance of emerging market economies to global growth. We encourage investors to look beyond the established indices and assess the merits of EMD in its own right when considering allocations.
Traditional portfolio allocation methods can facilitate discussions of EMD allocations. A research project that we developed in collaboration with a student team from MIT Sloan School of Management highlights our view that the relative value of EMD results in an allocation to EMD that significantly exceeds current index weights and investor portfolio allocations.
Rising interest rates pose a challenge for the performance of a diversified global fixed-income portfolio. Our sample portfolio allocation shows that in a rising-rates environment, EMD has the potential to outshine other fixed income classes. Investors who are concerned about rate hikes should focus on high-yield, hard-currency EMD (largely, the frontier markets). Among EM local currency assets, such investors should choose local currency (shorter duration) over local bonds, as the former will likely deliver better risk-adjusted returns.
EMD is maturing
EMD has evolved steadily as an asset class. A few decades ago, moderate issuance was concentrated in only a few markets. Increased breadth makes it a more investable asset class today. In 2017 the stock of emerging markets debt, as measured by the market capitalisation of prominent benchmark indices, topped USD 3 trillion for the first time. This stock was split fairly evenly between emerging market sovereign debt in local currencies (USD 1.2 trillion), emerging markets sovereign debt in hard currency (USD 913 billion) and emerging markets corporate debt in hard currency (USD 968 billion). Average annual growth rates in the stock of EM debt since 2003 have been 18%, 11% and 27% for local, HC and corporates, respectively. Net issuance in 2018 is likely to remain in the range seen over the past few years. External sovereigns and corporates are expected to raise USD 88 billion and USD 122 billion respectively.
In local markets, improving access will further expand investment opportunities. Deregulation is expected to open up the Chinese and Indian local bond markets to international investors, which will allow these bonds to enter major debt indices. Other countries such as Ukraine, Kazakhstan, Serbia and major African countries are set to follow suit, improving both the diversification and yield available in these markets.
At the moment, the important fundamental drivers look quite healthy. Past current account vulnerabilities have largely healed, except for a few countries like Turkey and Argentina; indeed, aggregated balances are now in surplus and inflation is benign. Although there are pockets of fiscal slippage, deficits are broadly manageable and local issuance is unlikely to increase materially.
Based on prognoses, the relative importance of EMD is set to increase. Higher economic growth in emerging markets is an important theme. Based on IMF estimates from April 2018, the average GDP growth rate over the next three years will be 5.1% for emerging markets, compared with 1.7% for the most advanced economies (G7). This translates into a strong growth differential of about 3.4% in favour of emerging markets. Emerging markets are also earlier in the growth cycle, which is likely to support valuations, as not only will growth continue at a higher level for longer, but central banks will not be in a rush to hike rates. On a purchasing-power-parity (PPP) basis, well over half of world GDP is already generated by emerging markets. By 2020 this is expected to be higher than 60%. On the other hand, emerging markets debt stock accounts for approximately 20% of total debt stock issued.
Why is EMD an underappreciated asset class?
More than half of the investors we surveyed cite an insufficient understanding of the asset class as a reason for the low allocation. The general perception of risk is an important concern for over three-quarters of the investors. Investors feel that a lack of knowledge on how to incorporate EMD in asset allocation inhibits their allocations.
Clearly, investors attach a higher country risk premium to EMD than suggested by historic risk/return profiles. Perhaps this bias has been shaped by the media, or by the lower levels of development in the countries associated with these bonds. A home bias also certainly plays a significant role.
We believe the market tends to overestimate the risks associated with EMD sovereign bonds. This has created a more favourable risk and return trade-off than other fixed income asset classes for the patient investor.
Looking beyond benchmark weights
Using the benchmark weights as a point of departure for portfolio construction of global fixed-income portfolios exposes investors to the risk of under-diversification and the loss of opportunity due to diminished return potential.
In practice, institutional investors’ allocation to EMD tends to be below or in line with the average benchmark allocation. On average, they seem to have missed out on the strong risk-adjusted performance we have seen in the past. The flip side of current investor positioning is that there is ample room for improvement that can be realised by simply allocating more to EMD.
EMD has demonstrated attractive long-term risk and return characteristics and we expect this trend to continue. Assessing EMD in this way can help investors to achieve global fixed-income portfolios that have better return/risk characteristics than those attainable solely via developed market credits.
We supervised a project run by students at the Sloan School of Management at the Massachusetts Institute of Technology (MIT Sloan) to look at what the optimal allocation to EMD in a global FI portfolio could be in a rising rates environment. This research was conducted by Mariano Aveledo, Richard Guo and Tomoko Muraki as part of their academic work for the MIT Sloan 2018 Finance Research Practicum. Their results provide an example of how an investor could perform portfolio construction that controls for volatility and drawdown risk.
The particular study we sponsored looked at how to maximise the portfolio Sharpe ratio with respect to historical drawdown constraints over a 1-year period. For example, if the risk budget provides for a drawdown of 5% total in a fixed income portfolio, what allocation to fixed-income categories optimises the Sharpe ratio of that portfolio? We considered U.S. and EU Aggregate benchmarks to proxy the developed market investment grade spectrum, and U.S. high-yield corporates for the sub-investment grade opportunity set. EMD is subdivided into external debt and local debt. The former is split between IG sovereigns, HY sovereigns and corporates. Local debt is split between local currency (low duration) and local bonds.
Our portfolio optimisation indicates that even investors with the lowest drawdown risk tolerance end up with an 8% allocation to EMD that is above average institutional investor allocation. This figure quickly increases to 26% when allowing for moderate drawdown risk of 5% on a 1-year horizon. EMD allocation increases to 35% for investors that allow drawdown risk at the high end of the spectrum.
Within EMD, high-yield external debt and local currency (JP Morgan ELMI+ as opposed to GBI-EM Global Diversified) are the most noteworthy asset classes in this optimization study. Local currency (JP Morgan ELMI+) is the preferred asset class for investors with a low risk tolerance, while HY external debt enters the portfolio at higher risk tolerance levels.
Our study supports the notion that institutional investors are under-allocated to EMD, and may benefit from increasing their allocations. Considerable portfolio improvement may be made possible by moving beyond benchmark weights and allocating to the asset class on its own merits.
EMD is an often underappreciated asset class. Investing in many of these developing countries evokes undue concern. We encourage investors to look past their biases and take a closer look at the data. Historical risk and return characteristics of EMD are quite compelling and tell a very different story. We encourage fixed income investors to include an allocation to EMD, also during a period of rising rates.
Interest rates are finally rising. For the better part of a decade, investors globally have been calling for the Fed to increase interest rates. In 2011, Bill Gross, then one of the world’s most influential fixed income investors, said investors needed to “exorcise” US bonds from their portfolios, as inflation was imminent. Following many virtually inflation-free years since then, the Federal Reserve is now clearly in a rate hiking cycle.
In a rising rates environment, local currency truly shines. The results of the study with MIT Sloan show that during periods of rising rates, local currency EMD is preferable to local bonds for allocation purposes, as the significant duration of the EM local bonds asset class adversely impacted risk and return ratios. For investors who are able to take more risk/larger drawdowns, hard currency frontier market debt (which is HY) is an attractive option to allocate to.
In historical rising-rates environments, allocating to emerging markets currencies boosted returns and diversified away risk as correlation between local currencies and US Treasury yields was surprisingly low. For example, we identified the period of July 2004 to July 2006 as one of rising rates, in which local currencies, as represented by JPM ELMI+ index, returned 9.8% with a Sharpe ratio of 1.91. This strong performance has been repeated in the current rising-rates environment with the index returns at 8.5% between February 2016 and December 2017. We believe that in the current rising-rates environment, local currencies offer an attractive opportunity for investors to add return and diversify risks. Emerging market currencies are undervalued on aggregate on a real effective exchange-rate basis.
Investors’ ability to generate strong returns in their domestic bond and equity markets without taking foreign currency risk partially explains this undervaluation. However, with yields so low and rising, and with equity markets arguably being overvalued, it is natural for investors to look more internationally to generate the returns necessary to meet future obligations.
Due to the increased openness, accessibility and liquidity of local emerging markets bonds, investors can now replicate the impressive risk-return characteristics of JPM ELMI+ index by buying Treasury bills and short-dated bonds in most of the emerging markets.
Download the article to read further:
This communication is intended for MiFID professional investors only. Click “Read more” for the full disclaimer.