How are investors making EMD work in their portfolios?

Investment industry flows data and our conversations with clients from across the globe suggest a renewed interest in the EMD asset class. So, for the third in our EMD in Discussion series, we invited four experienced institutional investors to share their views on the asset class with senior members of Ninety One’s investment team in a virtual roundtable.

• Watch the highlights below.
• Read the key takeaways below or download them here.
• You can also watch a related podcast interview with Victoria Harling here.

01. Long-term trends and cyclical turns

To start the roundtable, Ninety One’s Head of Fixed Income, Peter Eerdmans, briefly shared some of his thoughts on the asset class.

With crises, trade wars and corresponding market volatility, recent years have been anything but dull for investors in EMD. But, Peter explained, behind the attention-grabbing headlines, EMD has been steadily coming of age: the EMD investment universe has expanded and diversified, and many EM economies have forged sustainable debt paths, improved their fiscal health and granted independence to their central banks, to name just a few areas of progress.


Risk/return (since 31 December 2002)

Source Ninety One, Bloomberg, 31 August 2020. For illustrative purposes only.
Local EMD: JPM GBI-EM GD; Sovereign HC: JPM EMBI-GD; Corporate HC: JPM CEMBI-BD; Global Govt: BofA World Govt Bond Index; Global IG: BofA Global Corporate Index; Global HY: BofA Global High Yield Index; Global Equity: MSCI World; EM Equity: MSCI EM.
For further information on indices please see Important Information section.

With ‘lower for longer’ yields now a widely accepted reality and compelling current valuations, EMD has become an increasingly important asset class for investors, explained Peter. He shared the chart above to demonstrate the compelling risk premium hard currency EMD has offered investors over the long term, but added that local currency debt is a more complex category, given the two cycles experienced in the past 15 years – something we cover later in the context of local currency volatility.

02. An evolving – and diverging – role in investor portfolios

When the Alaska Permanent Fund began investing in EMD seven years ago it was as part of the $66 billion sovereign wealth fund’s special opportunities allocation, explained Alaska’s Masha Skuratovskaya. EMD is now part of Alaska’s fixed income portfolio, where the emphasis is on the income it delivers in a low-yielding world. While for US pension funds a fixed income allocation is usually synonymous with stability, capital protection, liquidity and low volatility, for Alaska the emphasis is on income. This translates into an appetite for volatility and an exploration of the complete fixed income universe – including EMD. And while 80% of Alaska’s fixed income assets are managed in-house, it entrusts the management of its EM and high-yield allocations to external active managers with the relevant specialist expertise.

In Europe, Martijn Vijver of Dutch pension scheme fiduciary manager, MN, said he is seeing a general increase in his clients’ allocations to EMD. Among MN’s client base there are many investors who recognise the diversification benefits and spread return potential of hard currency debt, while local currency debt is generally considered an alpha source for investors with a longer-term horizon.


$33 trillion of global debt now trades at less than 0.5% yield
 

Source: Ninety One, Haver, Bloomberg, June 2020

03. Keeping calm during the COVID-crisis market turmoil

When our roundtable panel’s discussion turned to the COVID-related market turmoil earlier this year, Ninety One’s Werner Gey van Pittius reflected on some of the doom-laden news stories focusing on EM debt. Despite the headlines, Werner pointed out that the economic impact of COVID-19 is likely to result in the same increase in debt levels as seen in previous crises and well below the increase we expect to see in developed markets. While higher debt levels will weigh on economies, they should not cause concern for investors, he said. As for asset class performance, Werner added that as is typical in a crisis, investment-grade markets were first to stage a sharp recovery, followed by high-yield, and now it’s the turn of FX to pull back from its lows.


Spreads

Source: Bloomberg, JP Morgan. Dollar debt: EMBI Global Diversified; Corporate: CEMBI Broad Diversified. For further information on indices, please see the Important information section.

Although liquidity withdrawals precluded the Alaska Permanent Fund from doing so, Masha Skuratovskaya explained that at the height of the market turmoil the sovereign wealth fund would probably have added to its EMD allocation, given its philosophy of seeking opportunities when heightened uncertainty amplifies market inefficiency.

Meanwhile, MN’s Martijn Vijver explained that COVID-related FX volatility caused a significant number of client questions, however, sticking with the strategic allocation has paid off, given the surprisingly strong market rebound.

The discussion returned to COVID-related turmoil in the context of the risks associated with EM corporate credit investing. Ninety One’s Victoria Harling spoke of the subsequent strong market rebound while noting how the liquidity aspect of EM corporate debt can create short-term drawdown situations as witnessed in March. She added that if investors have a long-term investment horizon they will be exposed to a compelling risk-return profile; more on that later.

04. Local currency volatility can be friend or foe

Our roundtable participants are no strangers to the vagaries of local currency markets, where – Peter Eerdmans explained – investors have seen two distinct cycles over the past 15 years (a topic we covered in our paper ‘Emerging markets: cycles past and future’) and a short and sharp sell-off earlier this year. Peter’s view is that as the world returns to growth, it would be a mistake to extrapolate the mediocre return seen over the most recent cycle. Instead, he thinks local currency debt investors could expect solid return potential – even if this may not match the outsized returns of the early 2000’s cycle.

But can investors stomach the associated volatility?

While recognising that lower volatility approaches to local currency debt are available to investors, Lene Boserup explained that Industriens Pension is keen to capture the full upside potential. Rather than adopting a strategy that limits volatility (and, by definition, reduces upside capture potential) and in recognition that volatility in local debt has been greater than anticipated, Industriens has reduced its allocation to local debt from a half to a third of the scheme’s EMD exposure, but it has not changed its investment approach. Industriens invests in EM local debt on an unhedged basis as FX market moves represent a key source of alpha that it does not want to miss out on. Yet smaller investors are more averse to FX volatility, explained Kirstein’s Jan Willers. These investors typically hedge FX exposure, and volatility is still a concern that is keeping investors’ focus more on the hard currency debt side of things.

It is well understood at the Alaska Permanent Fund that volatility comes with the territory, according to Masha Skuratovskaya. Alaska mainly takes EM FX risk in the fund’s (unhedged) EM equity allocation, with FX risk taken in fixed income allocations where it is not cost effective to hedge – a decision Alaska leaves to the discretion of its external managers, while limiting to overall local debt allocation to 5% to keep a lid on volatility.


Volatility (rolling 3-year)
 

Source Ninety One, Bloomberg, August 31 2020. For illustrative purposes only. For further information on indices please see Important Information section. Local EMD: JPM GBI-EM GD; Sovereign HC: JPM EMBI-GD; Corporate HC: JPM CEMBI-BD.

05. EM corporate credit: mature but still misjudged

To believe that investing in EM Corporate Credit exposes investors to EM equity-like risks is to misunderstand the fundamentals of the asset class, explained Victoria. Vic acknowledged that – just as in DM – as you move down credit curve, the correlation between debt and equities rises. But she added that the EM corporate market has become a lot more diversified in the past decade, with the growth of Asian credit contributing to the growth of the investment-grade universe.

This is helping to change the perception of the asset class, with investment grade and high yield now two very distinct components, and regional diversification also a reality today. In the investment-grade segment, investors can find many big blue chips that enjoy a global footprint, diversified funding bases and good support from banks, and the result of these impressive fundamentals is that the asset class’s volatility is a lot lower than many assume.

Vic noted that in the last few years she has seen significant demand from investors who are recognising the appeal of EM corporate as a complement to existing developed market credit exposure and looking to benefit from the higher spread EM corporates offer relative to DM corporates of a comparable credit quality.

Hear more from Victoria in her latest podcast interview:



Industriens is among investors who recognise the superior risk/return profile corporate debt can offer relative to sovereign debt in some markets, explained Lene Boserup. That’s why Industriens allows its hard currency debt allocation to be split between the two. Meanwhile, Martijn Vijver explained that although a preference for fewer, large mandates restricts it from making dedicated EM corporate allocations, MN does allow its hard currency managers to invest in quasi-sovereign debt – where he recognises there is significant value – as long as issuers are 100% state-owned.

06. Are investors using the whole tool-kit?

Staying on the topic of EM corporate credit, for the Alaska Permanent Fund it is an important component of its external EMD managers’ toolkits. Although Alaska does not have a dedicated allocation to EM corporate, it is happy for its EMD partners to allocate a percentage of their portfolio to corporate debt as it understands that national champions’ debt often stacks up favourably against the corresponding sovereign credit from a credit quality, liquidity and or/visibility perspective. The relative merits of a corporate and sovereign position in a particular market is a regular topic of discussion between Alaska and its external EMD managers.


Rising interest in EM corporate credit
 

Source: Kirstein A/S based on interviews and quantitative data from 27 Nordic investors Combined assets covered in the research is close EUR 500 billion excluding banks and distribution. Y-axis scale: level of interest (1 = lowest; 5 = highest).

Kirstein has seen pick up in dedicated EM corporate allocations among its clients, noted Jan Willars. Yet investors are currently underweight EMC – a fact borne out in a survey conducted by Kirstein last year.

But this may soon change, he added. The coming of age of the EMC asset class has sparked significant interest – albeit little action – in the past few years. Willers believes local currency market volatility and underperformance by some asset managers could be a potential catalyst for investors to put their money where their mouth is when it comes to making a dedicated EMC allocation.

For its part, Industriens is doing just that, explained Lene Boserup, the process has just been delayed slightly by the COVID crisis.

07. Navigating an increasingly diverse investment universe

While fundamentals may be solid for emerging nations overall, there is significant variation within the country group. Debt/GDP ratios range from well over 100% in Brazil to about 20% in Russia. Against this backdrop, and with the gaps widening as COVID-19 puts the global economy under heavy strain, bottom-up investing will be key, explained Peter Eerdmans. This sentiment was echoed by MN’s Martijn Vijver, who stressed the importance MN places on its external managers differentiating between economies that are well-managed and those where there are concerns around economic stewardship.


Large fiscal deficits in some markets...


...exacerbating divergence in debt/GDP levels
 

Source: Ninety One analyst forecasts, as at July 2020.

08. Sustainability: shifting up a gear

While it is clear that sustainability is a central concern for many investors, a new sense of urgency around finding more effective approaches to integrate the full spectrum of ESG considerations into investment decision-making has recently come to the fore.

Peter Eerdmans described how the COVID-19 pandemic has, on one hand, highlighted the importance of effective social safety nets and, on the other, prompted talk of a ‘green recovery’. A crisis could be turned into an opportunity.

Considering that most of the planet’s natural resources are located in emerging markets, it is vital for EMD investors to push the boundaries on integrating environmental risk in their investment processes, according to Peter. This means new tools and approaches as well as genuine efforts to engage with sovereigns to help encourage them to do the right thing.

The expectation among investors is clear: during the discussion on EM corporate debt investing, Jan Willers emphasised the central role of ESG considerations for Kirstein’s investors, who expect ESG to be integrated fully and meaningfully into managers’ processes.

Biographies

Peter Eerdmans is Head Fixed Income and Co-Head of Emerging Market Sovereign & FX at Ninety One. He is jointly responsible with Werner Gey van Pittius for all global emerging market sovereign debt strategies. Peter is also responsible for top-down analysis within the team. He joined the firm in 2005 from Watson Wyatt, where he was responsible for bond and currency manager research. Prior to his time at Watson Wyatt, he spent six years as a senior portfolio manager responsible for global bond management at Robeco, where he helped develop the credit process and lead on numerous projects improving. the process and tools of the department. He graduated in 1995 with a Master’s degree in Econometrics from Erasmus University Rotterdam.

Werner Gey van Pittius is Co-Head of Emerging Market Sovereign & FX at Ninety One. He is jointly responsible with Peter Eerdmans for all global emerging market sovereign debt strategies. Werner is also responsible for EEMEA research in the team. He moved to London from Cape Town where he was a fixed income quantitative analyst and managed Ninety One’s asset and liability matching book. Prior to Ninety One, Werner played professional rugby in concurrence with academic programmes. He holds a Bachelor of Commerce degree in Insurance Science from the University of Pretoria, a Bachelor of Commerce (Hons) degree in Financial Economics from the University of Stellenbosch, and a Master of Science degree in Applied Statistics from Oxford University. In addition, Werner obtained the Society of Technical Analysts diploma and was awarded the Chartered Financial Analyst (CFA) designation from the CFA Institute in 2006.

Victoria Harling is Head of Emerging Market Corporate Debt and is responsible for managing the Emerging Market Corporate Debt Strategy and the Emerging Market Investment Grade Corporate Debt Strategy at Ninety One. Victoria joined Ninety One in 2011 from Nomura International. Victoria previously spent over three years working with emerging market trading desks and capital markets teams for Standard Bank and Nomura. She also spent two years running hedge fund and proprietary trading strategies for Rand Merchant Bank and Whitebeam Capital Management. Prior to this, Victoria spent over eight years working for Henderson Global Investors where she was responsible for running emerging market debt portfolios. Victoria graduated from Leeds University with a Bachelor of Science degree in Biochemistry with Molecular Biology. In addition, she has passed CFA Level III.

Lene Boserup, CFA, is senior portfolio manager at Industriens Pension Scheme that manages the labour market pension scheme for industrial employees in Denmark. Lene oversees the external managers on liquid and illiquid credit. Prior jo joining Industriens Pension in September 2018, Lene was at Nykredit Asset Management, in alternative investments and manager selection responsible for the fixed income business from 2013 to 2018. Prior to that she has been Senior Fixed Income Specialist, corporate bonds at Nordea, SEB Client manager for international institutional clients on fixed income strategies at Danske Markets, ABN Amro and Nordea Markets.

Jan Willers is a partner and COO at Kirstein (which advises asset managers with a strong presence in Northern Europe). He has been a partner since 2012 with a focus on developing the business with an international perspective. Jan is responsible for market analyses of investment tendencies and preferences in continental Europe including advising on the future role of the asset management industry.

Martijn Vijver, CFA, has been a senior fund manager at MN since January 2013. He is responsible for selection & monitoring of fixed income managers on asset classes ranging from Euro government bonds, investment grade credits to high yield and emerging market debt. He has over 19 years of experience in the investment and pension industry. Prior to MN, he has held similar roles at Watson Wyatt (both in the Netherlands and UK), Russell Investments (London), SAMCo (Shell)

Masha Skuratovskaya, CFA, is part of the team that runs the Fixed Income Plus mandate for the Alaska Permanent Fund Corporation (APFC). Her day to day responsibilities include management and oversight of Global, Emerging Markets and Inflation portfolios as well as setting overall interest rate strategy for the Fixed Income Plus mandate


Important information

Indices:

Indices are shown for illustrative purposes only, are unmanaged and do not take into account market conditions or the costs associated with investing. Further, the manager’s strategy may deploy investment techniques and instruments not used to generate Index performance. For this reason, the performance of the manager and the Indices are not directly comparable.

General risks:

All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.

Specific risks:

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Liquidity: There may be insufficient buyers or sellers of particular investments giving rise to delays in trading and being able to make settlements, and/or large fluctuations in value. This may lead to larger financial losses than might be anticipated.