Despite the weaker sentiment that is surrounding emerging market (EM) assets at the moment, the fundamental arguments for holding corporate and sovereign debt issued by the developing nations remain firmly in place. In this article, we discuss EM debt, the current market, the reasons for and against investing and how insurers can take advantage of this relatively junior asset class.
Technical factors are broadly supportive. Sovereign issuance is relatively low net of coupons and amortisations and, in terms of valuations, EM debt looks reasonably attractive versus developed market corporate bonds following the yield spread widening that occurred over the summer.
EM countries benefit from an array of secular growth drivers. These include positive demographics (young, growing and dynamic populations), improving governance (both corporate and government), increasing industrialisation and economic reform. Many also have the advantage of sound fiscal and monetary policies and rising credit worthiness. This has improved liquidity, making it easier for institutional and retail investors to raise their weightings in an asset class in which they have historically had very low exposure.
EM debt has become an important source of diversification in a balanced portfolio because of its low correlation with other asset classes and compelling income opportunities. Fund managers also have a broad array of options to generate attractive total returns because of the multi-layered and under-researched nature of the market.
EM debt is nevertheless suffering a crisis of confidence that is reflecting investors’ concerns about economic growth and monetary policy in a number of countries and the withdrawal of liquidity support (quantitative easing) in the US.
Many of the factors that are causing retail investors to sell out of EM bond markets are not, however, structural. For this reason we see the recent sell-off as an opportunity for investors to buy back into the market and lock in very competitive yields. Some Brazilian bonds, for example, are currently yielding in the high teens.
Following recent currency weakness and higher interest rates in certain countries that are sensitive to the US Federal Reserve’s tapering of quantitative easing, EM growth data may lag further in the months ahead. However, we note that expectations have already been revised down, meaning there is scope for positive surprises on the upside. Of the other factors that drive sovereign creditworthiness, inflation has continued to stay low and policy credibility is improving in countries such as Mexico, Indonesia and Slovenia.
The Fed’s tapering of quantitative easing is now firmly underway. Nonetheless we expect the US interest rates to remain low for some time, so “tight” policy in an absolute sense is some way off. An interesting side effect of tapering is an expected recovery of the dollar, which would create a useful tailwind for those invested in EM bonds at are denominated in the US currency.
As liquidity becomes less abundant in EM, capital flows to EM countries may require a higher prospective return, which is already putting pressure on countries that have slow growth and/or external deficits. The main impact should be on currencies and equities, and we expect sovereign yield spreads to be cushioned by strong external balance sheets.
The most significant near-term threat to the market is an overshoot in US treasury yields, particularly since these are now more correlated with EM spreads. Another risk comes from emerging market currency weakness. Should central banks be forced to follow the recent example of Turkey and hike interest rates aggressively in a desperate attempt to protect currencies, EM growth expectations could be forced down across the board. Political risk is also elevated, with upcoming elections in Brazil, Indonesia, India, South Africa and Turkey and a repeat of the US government shutdown/debt ceiling debate being potential sources of volatility.
The F&C View
Our continued optimism towards the debt markets is based on the slow if steady recovery of the global economy. We expect the US to continue to lead the way, with increasing support from Japan and the Eurozone. This should trigger a rebound in EM exports and put a floor under commodity prices. The continued strength of the Chinese economy is another important prop to debt markets and, although growth there is expected to continue to gradually decelerate due to structural factors, we do not expect a hard landing.
In 2013 value was created in the EM debt market and we see 2014 as more about being selective. The main line of demarcation will be between the so-called ‘fragile five’ of Brazil, Indonesia, India, South Africa and Turkey and nations where there are tangible signs of improvement, such as China, Taiwan, Thailand and Korea. It’s a scenario that plays well into our investment philosophy at F&C as we seek to add value through exploiting short-term spread distortions and anticipate longer term spread changes between individual issuers. With so much disruption in the market, we have more scope to identify relative value between bonds from the same issuer, corporates, currencies and local currency bonds.
Impact on Insurers
Insurers continue to find the search for yield difficult. Whilst more efficient asset solutions are being sought and further asset diversification promoted, insurers are naturally sceptical of committing themselves to a relatively new asset class. In the case of EM debt, exposure can become untenable for insurers because of the negative impact on the capital cost, a function of duration and credit rating.
Insurers should nevertheless not immediately dismiss EM debt as it can offer attractive uncorrelated diversification benefits compared to other assets classes within a portfolio. An assessment therefore needs to be made to weigh up the capital cost against the benefits of potential yield uplift and diversification.
Insurers may therefore need to work with their asset managers to construct the most efficient and effective portfolio.
This document has been produced for the information of investment professionals only and should not be construed as investment advice. Past performance should not be seen as an indication of future performance. Stock markets and currency movements may cause the value of investments and the income from them to fall as well as rise and investors may not get back the amount they originally invested. All sources F&C Management Limited unless otherwise stated. F&C Management Limited is Authorised and regulated by the Financial Conduct Authority FRN:119230. Limited by shares. Registered in England and Wales, No. 517895. Registered address and Head Office: Exchange House, Primrose Street, London EC2A 2NY F&C Asset Management plc is the listed holding company of the F&C group. F&C Management Limited is a member of the F&C Group of companies and a subsidiary of F&C Asset Management plc.F&C, the F&C logo, reo and the “reo” logo are registered trademarks of F&C Asset Management plc. F&C Investments and the F&C Investments logo are trademarks of F&C Management Limited.© F&C Management Limited 2014.
This article first appeared in ‘Insurance Asset Management, Europe 2014’ published by Clear Path Analysis. For more information, please visit www.clearpathanalysis.com