Despite the summer’s volatility in emerging market debt (EMD), institutional client’s interest has steadily increased over the past 12-18 months. We have seen interest across a variety of institutional client types, including insurance companies, pension schemes, and large asset allocators. Unlike previous moves that were more valuation driven or opportunistic in nature, the most recent discussions reflected a strategic interest in emerging market debt.
Among institutions, we see a growing comfort with emerging market dynamics. This is visible in their more sophisticated (and varied) reactions to events in emerging markets versus the previous approach that tended to consolidate emerging markets risk into a single basket. For those institutions that have maintained EMD exposure over the long term, we note a deepening structural engagement. We see institutions shifting away from tactical allocations toward a strategic allocation to emerging markets, and/or an increased weighting in emerging market debt.
Among institutions that have traditionally relied on domestic or core bonds for income, the demand for diversification into EMD continues to increase. This is especially visible in short duration, higher quality EMD strategies with yield targets.
In addition, we believe there are two main structural factors driving interest in EMD that should continue to support the case for increased EMD allocations in global diversified portfolio.
1) EMD has evolved into a more sizable and deeper opportunity set within global fixed income
Today the total market cap of EMD stands at USD 19trillion, around 25% of the global bond market. This includes bonds from over 70 EM sovereigns and more than 800 EM corporates. The market cap and number of issuers of hard currency EM corporate bonds, for example, already rivals those of the US high yield bond market. A deeper market presents institutional investors with plenty of flexibility when investing in the asset class even with restrictive, customised guidelines. For example, in 2000, there were 21 investment grade sovereign/quasi sovereign issuers within the universe and today this number has grown to 79.
2) Moderate correlation with core fixed income helps to improve the efficient frontier
EMD can provide diversification to traditional core fixed income portfolios due to its relatively low correlation with these assets (see matrix chart below). For example, adding EM corporates to a global government portfolio shows an improved efficient frontier, as illustrated below.
The historical data shows that having emerging market bonds in a diversified portfolio can improve total return over the long run. However, the trade-off has been periodically greater volatility and increased sensitivity to global macro events.
So what is the appropriate size of a strategic allocation? In our view, it depends on the individual investment objectives and risk appetite. Client engagement is critical in discussing the risk/benefit and ultimate weighting in the sector. We believe the long term potential in emerging economies and thus the asset class is compelling. Overall, the average institutional investors’ allocation to EMD is not commensurate with the relative size of the EMD market as shown on the chart below. If you haven’t made EMD a priority lately, you might consider how it’s evolved, and how it can work for your plan.