Emerging market debt: a high yield but risky option

With interest rates low some investors are exploring new territory in their search for income. One such frontier is emerging market debt funds.

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  1. Rob Morgan

With interest rates remaining low, some investors have exploring more risky areas in their search for income. One is emerging market debt funds. These offer tempting yields in the region of 5%, but they can also come with high volatility. So, what are the opportunities in this area of investment, and is the income on offer worth the risks?

An evolving asset class

For many years investors have appreciated the appeal of emerging market equities. For some time the developing world has presented exciting investment opportunities with its growing, youthful populations and increasing middle-class spending power. Yet fixed interest funds in these markets have remained a more esoteric investment, perhaps because yield-seeking investors are typically more cautious. They often rely on the income and wish to avoid significant volatility of capital. The additional risks of emerging markets such as currency movements and political upheaval seem at odds with this objective.

However, emerging markets have evolved over the past couple of decades. Many nations have become more creditworthy, built on solid economic foundations with lower debt levels than in the past. In addition, high inflation (and resultant currency devaluation) which previously deterred investors has abated. Political reforms and central bank independence have gone a long way to addressing the issue but it remains a risk. Indeed, it has been highlighted again this year as emerging market currencies have come under pressure from rising US interest rates and trade war rhetoric.

Understanding the diversity

Drill down into the asset class and there is much more to understand. For a start, there are the different areas of emerging market debt. Essentially, the asset class can be divided into three categories: ‘Sovereign’ debt issued by governments in local currency; sovereign debt denominated in ‘hard’ currency (meaning US dollars); and debt issued by companies (corporate debt) – this can also be local or hard currency.

Emerging market sovereign debt has shown a steady improvement in quality with nations such as Mexico offering a high credit rating but relatively low yields. Countries with higher credit risks still offer higher yields – but clearly with higher risks as recent problems in Argentina and Turkey demonstrate. Finances in both countries deteriorated rapidly, burdened by large current-account and fiscal deficits.  Yet in some investment grade emerging markets debt is been paid back at a faster rate than new borrowing – meaning the market is shrinking – thus the balance between supply and demand can be supportive of prices.

This is especially the case for hard currency debt which is increasingly being replaced by local currency debt as nations prefer to borrow in their own currency where possible. So although sticking to area this restricts fund managers to fewer choices it may retain some ‘rarity’ value and is seen as a more conservative strategy. The currencies of emerging markets tend to be more volatile than the dollar meaning local currency debt can exhibit bumpier returns unless currency moves are hedged by the manager.

Over the years emerging market corporate debt has developed into an asset class in itself. As with developed markets, emerging market corporate bonds are publically-traded debt instruments issued by companies. These can offer investors a higher yield in compensation for the fact that companies are, generally speaking, more likely to default on their debt than governments. It means, however, that yields are typically higher. There is also great variety as there are many different kinds of companies with varying risk levels.

Where to invest?

The emerging market debt universe represents hundreds of sovereign and corporate issuers across more than 60 countries. Given this breadth of choice funds specialising in this area vary considerably. Hard currency, local currency and corporate bonds are held in different proportions. Some stick to just one area, others roam across all types. It is therefore necessary to look at whether you are comparing apples with apples, especially since there is often significant disparity of returns from the best and worst parts of the market.

The ultimate decision whether to invest comes down to whether the yield on offer is sufficient compensation for the risks involved. An active fund manager focused on picking the best countries or parts of the market while avoiding the worst has the potential to add a lot of value - although this is not guaranteed and they could underperform the market if they make the wrong calls. Considerable resource on the ground, as well as sound judgment in terms of economic and political views, is vital for successful investing.

Our pick in the sector

We believe a blended approach to emerging market debt with a flexible allocation to local currency, hard currency and corporate debt is a sensible way to invest in the area over the longer term. Having the widest variety of possible assets aids diversification and allows a fund manager to fully express their views.

We believe Investec Emerging Markets Blended Debt is worth considering in this regard. It aims to beat a hybrid benchmark of 50% US Dollar debt, 30% local currency debt and 20% corporate debt. The managers’ universe is over 1,100 individual bonds issued by more than 550 issuers across 12 sectors in over 60 countries – plus the fund aims to make currency calls to add value too.

There is a highly structured investment process and an extensive top-down view, expressed via a country ‘score’, which is together by meeting nations’ ministers of finance, debt management offices, economic ministers, central bank heads, the IMF, the World Bank, journalists, political opposition and local banks.

In terms of recent performance, the fund had a fair year versus competitors, doing well out of the Turkish turmoil, selling out and subsequently back in at depressed valuations. This is an example of how agile the fund can be. In addition, the fund’s Egyptian assets generally enjoyed a strong year due to the ongoing recovery in foreign investment into the country, which has been triggered by a successful government reform programme.

Having previously had a preference for hard currency debt for both sovereign and corporate exposure, the managers have grown more positive on emerging currencies this year following the general sell off across in emerging market assets. They now believe they are attractively valued given the difference between economic growth rates in emerging nations versus developed markets is expected to continue widening in their favour.

The most significant country weight is Brazil at 11%, followed by South Africa, Indonesia and Mexico. This demonstrates the geographic diversity of the fund, although the managers acknowledge that the entire asset class can be affected by overall investor sentiment, and rising US interest rates continue to be a headwind for virtually all nations across the emerging world. In general, a strong US dollar is troublesome as countries and companies with dollar-denominated debt tend to be put under more financial pressure – so a steeper trajectory for US interest rates – which in turn propels the dollar – than expected is ordinarily a negative.

Emerging market debt can be an interesting means to diversify and boost the income of a portfolio. For instance, this fund currently yields an attractive 5.8% (variable, not guaranteed). However, this asset class should only ever be a small component of a portfolio. There is a high level of volatility as the area tends to be heavily influenced by investor confidence, which can grow and subside quickly.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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