Yield and currency: a right mix in emerging market debt

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Thanks to the US$16 trillion-or so of bonds globally in negative-yield territory, investors are seeking out new, and old, yield-bearing securities. Private credit is popular and, increasingly, so is emerging market debt, both of which provide higher yields and, when managed prudently, a potentially smoother ride with returns.

Aviva Investors recently produced a paper that demonstrates emerging market debt (EMD) can serve two masters, according to Divyesh Bhana, the firm’s head of client solutions for Australia. They are: “as an equity replacement, for investors concerned about where we are in the cycle; and, as a diversifier of credit exposures, because of the higher yield and different risk characteristics and correlations”.

The paper, written by Stuart Ritson for Australian and New Zealand institutional investors, says the diversification benefits show up dramatically as the asset class spans across a large number of countries and economies, and various sources of return. “Furthermore, emerging market debt offers diversification compared to higher‐yielding bonds in developed markets, as these typically have a higher positive correlation with developed market equities,” the paper says. “We believe that risk premia are elevated in EMD, presenting an attractive entry opportunity for long-term investors.”

Ritson is an emerging market debt portfolio manager for Aviva Investors currently based in Singapore, having previously worked for the firm in London. His portfolio focuses on local currency emerging market bonds rather than debt issued in hard currencies, such as the US dollar and euro. A native of New Zealand, he started his career as a currency analyst with the Bank of New Zealand in Wellington.

“At any given time, hard and local currency bond returns can diverge,” Ritson said separately, in an interview. “For the last few years, hard currency debt has outperformed because the US dollar has been stronger, and that looks like continuing for the time being. US yields are relatively high and the [US] dollar tends to appreciate towards the end of a business cycle… But our screens say that the US dollar is very expensive. The biggest opportunity lies in local currency EM bonds over a multi-year timeframe.”

He said there was increasing appetite for EMD in the Australasian region. Within the most widely followed EM benchmarks, roughly 20 per cent of hard currency bonds are issued by Asian countries while the proportion is closer to a third for local currency bonds.

The paper says: “Hedging the local currency exposure removes a significant portion of the returns (local cash rates) and the potential to gain from an appreciation of emerging market currencies over the longer term…“With attractive EM currency valuations, and the A$ closer to fair value, we believe there is scope for unhedged EM local returns to pick up in the future. The return pickup is likely in absolute terms, as well as relative to hard currency bonds, as FX hedging will not provide the same tailwind going forward given the cash rate compression between Australia and the US.”

The paper argues that of the three main approaches that can be used to access EMD – ‘silos’ of investments across the portfolio, blended, and a total return approach – for most Australian investors a blended approach will be optimal. For an average Australian balanced fund, about 50 per cent of the risk is in equities.

The EMD local currency correlation to Australian equities is only 0.01, but the hard-currency correlation is 0.46. When you invest through hard currencies, you get both the credit risk from the EMD plus the duration risk of the yield curve of the currency it has been issued in. With local currency, you get the local yield curve and the currency impact.

Local currencies did very well until 2018 but this year, with the trade war between the US and China in particular, investing in EMD through hard currencies has returned 13 per cent, versus eight per cent through local currencies.

According to Bhana, the main risks going forward include:

  • an escalation in the trade war
  • if stimulus in China underwhelms, and
  • a global recession.

In Aviva Investors’ latest House View, the firm estimated there is a one-in-three chance of a global recession, although should it occur it is unlikely to be a deep one. However, the firm does not believe the trade war is going away anytime soon, even if the current US administration loses the next election scheduled for the end of 2020. And it goes beyond the US and China. It affects Australia and other major economies too.

An option for super funds to consider is to think about their fixed income portfolios a little differently, which Bhana says is a growing trend in Australia. “Rather than putting strategies such as EMD and private credit into an alternatives bucket for portfolio construction, they are allocating to ‘growth fixed income’ and ‘defensive fixed income’. The ‘growth’ part of the portfolio would include EMD and private credit,” he says.

Another trend, Ritson says, is for institutional investors to integrate environmental, social and governance (ESG) factors throughout their portfolios, including fixed income. “Aviva Investors has been at the forefront of ESG investing across several decades and was one of the founding signatories to the UN’s Principles for Responsible Investment. In terms of EMD, it’s an ongoing but important process. We have, in the EMD team, created an ESG tool that gives each country a rating covering the full scope of inputs. Aviva Investors has a large ESG research team, which provides useful insight that informs our investment decisions.”

– G.B.

Note: Aviva Investors is a sponsor of Investor Strategy News

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