Fund Buyer Index

Three steps to bond heaven

Posted in Jan 2013

Interest has certainly increased in the past few years as rapid growth with solid fiscal metrics in the emerging market economies has outstripped growth in the developed world. Nevertheless investors still need to decide which emerging market debt asset class might be appropriate for them.

There are three classes: dollar-denominated sovereign debt, dollar-denominated corporate debt and local currency government debt. All three have delivered strong returns over different time periods and so deserve serious consideration. Basically, if you believe that the global economy will grow strongly over the coming years, then local currency government debt should be considered as any performance could be enhanced by a foreign exchange element.

However, if you believe that the global economy will suffer, then it is likely that hard currency sovereign debt would do better than local-denominated debt, due to its lower beta or less risky attributes. In terms of emerging market corporate debt, this can offer investors a more direct route perhaps into the emerging markets of Asia rather than the two government debt categories.

Local yields, local factors

Clearly, local currency emerging market debt offers investors exposure to local yields, which are typically driven by home-grown macroeconomic influences such as inflation, monetary policy, currency fluctuations, and supply and demand issues. However, both debt and currencies in emerging markets are more than likely to provide long-term positive returns over the coming decades as emerging market fundamentals converge with those of the developed markets.

Flight to quality

Investing in emerging market local currency debt clearly means taking on additional foreign exchange risk, given that the hard currency approach has an investment track record of nearly 20 years. Hard currency bonds also trade as a spread over US treasuries, which has the advantage of some protection if there were a flight to quality in times of uncertainty within the investment world.

However, in terms of the various asset classes under consideration, local currency debt does appear to offer greater diversification benefits than that of the two dollar-denominated categories. Allowing for the added currency risk, nonetheless, what could be considered for those investors who are prepared to delegate the asset allocation decision to a specialist manager is a blended approach towards emerging market debt.

This would give the investor exposure to both local and hard currency strategies, but with the added advantage of having specialist managers making active decisions dependent on market conditions.

Blended benefits

With regards to this blended approach, the Investec Emerging Markets Local Currency Debt Fund, managed by Peter Eerdmans, a highly skilled portfolio manager, could be considered. The fund offers investors exposure to both corporate and sovereign bonds, which may be issued in either local or hard currencies. The fund can also use derivatives, including currency, interest rate and credit default swaps, and forward transactions to assist in the efficiencies of managing the portfolio.

Debt and currencies in emerging markets are more than likely to provide long-term positive returns as fundamentals converge with those of the developed markets

Peter Lowman
Chief Investment Officer, Investment Quorum

It aims to focus on those local currency bond markets that offer excellent opportunities and has a current distribution yield of around 6.2%. Given the demographic changes that are very apparent in today’s world, the inclusion of emerging market debt within a global asset allocation is certainly gaining traction and will undoubtedly be debated further over the coming years.

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