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make sure that as part of a multi-asset port- folio we can deliver good risk-adjusted returns and these are a good diversifier.” For Dan Kemp, chief investment officer for Europe, Middle East and Africa at Morning- star Investment Management Europe, this is precisely the way to approach it. “As with any investment, you have to look at their relative value,” Kemp says, “and emerging markets look relatively attractive compared to other assets.” Morningstar has a sizable exposure to emerging market debt in its portfolio. Kemp says much of the traditional market reluctance to buy into these markets has been based on sentiment, but this can be misplaced.
“These bonds have underperformed other types of fixed income and some investors have been put off by recent performance,” Kemp says. “This means things are getting cheaper – on a relative and an absolute basis – which makes them more, not less, attractive.” He says that some investors were con- cerned about trading, liquidity and geopoli- tics, which should always be considered, “but the best determinant is value and a lot of the bad news is already priced in.” However, even if many investors are con- vinced of the fundamental ethos behind holding
emerging market debt, there
remains one major hurdle for them. “You have to be careful with emerging mar- ket debt,” Thompson says. “There is cur- rency risk and quite a bit of it cannot be hedged at a sensible price, so that leaves you with hard currency – dollars – which brings in the risk of default. There are a few areas having real trouble at the moment.” A case in point is Argentina. Hit by political turmoil, the South American country may have been able to cover its debts were it not for a US currency that was shooting further and further north. Alongside the default risk, the dollar affects emerging markets in various ways, Morningstar’s Kemp says. “The hard currency returns are in dollars, so if you own an asset priced in an alterna- tive currency, it is going to be difficult to hedge out and when the dollar is strong, it raises the likelihood of default.”
However, this – for the moment at least – might be a story confined to 2018. “Now the US has stopped raising rates (although it may raise them a little bit more) the dollar has stabilised, and a stable dollar is good for emerging markets,” Faw- cett says. “It doesn’t have to be depreciating and it depends on other forces as well, but it is one of the key factors. In the shorter term it is certainly a positive for emerging markets, for equities and debt.”
NEW KID ON THE BLOCK
This stable ground for the dollar has hit at the perfect time for China, ironically, as its debt is to be included in a major index for the first time. From April, the Bloomberg Barclays Global Aggregate Bond index will feature Chinese bonds, rising to eventually make up around 6%. In addition, Standard & Poor’s is the first rating agency to be given the go-ahead by the People’s Bank of China to rate issu- ers in the onshore bond market. All this should increase transparency and accessibility in the market, which is attrac- tive to developed market investors. For Visavadia, China’s appearance in the benchmark encapsulates the aspects all emerging markets are grappling with: gov- ernance, transparency and fairness. “That the authorities are behind these changes is good for investors and it gives us exposure to one of the largest economies in the world – and some good quality compa- nies,” he says. Brunel’s Mansley cited “a growing number of world class companies as well as inter- esting niche business able to access par- ticular opportunities,” as reasons to access the region. NEST’s Fawcett says he would be carefully considering which parts of the Chinese mar- ket he wants the DC scheme to invest in. “Large parts of the corporate sector are highly indebted, so we might want to be cautious,” he adds. “But China is a massive creditor nation. Government debt is not going to default so, depending on the spreads, it could be potentially attractive.” This step by China – and the financial insti- tutions making it possible – should have a
bigger impact, according to Kemp. “It will force some people who have only ever traded developed market bonds to look at emerging markets and it may make a dif- ference to the perception of the regions and get them to have a dig around in other countries,” he says. This is key to under- standing and making the asset class work in a portfolio, Kemp adds.
“Emerging market debt is very diverse. South Africa, Russia, Mexico – they all have their own benefits and challenges. And they all have different relationships with each other. It is not just one large trading bloc.”
UNDER THE BONNET Kemp is doubtful that investors understand the myriad complexities of emerging mar- kets, as few look on what he sees as the nec- essary granular level.
“When people are faced with a problem, they look for a simple solution,” he says. “They look at emerging markets and impose political news on the asset class as a whole, instead of looking at individual markets.”
This way of looking at the sector can often inform investors’ views on how to approach it. “Most investors stick to one of the large indexes, but active investors can add value in emerging markets,” Kemp says. Because of liquidity and other middle and back office reasons, transaction costs have been quite high with emerging market debt, Kemp adds, but that should be some- thing to prepare for rather than use as a reason to avoid it. “How you access emerging markets is important,” Visavadia says. Instead of index-hugging, he adds, investors need to give managers flexibility. “An absolute return approach means you don’t have to follow the benchmark, a lot of which is sovereign debt,” Visavadia says. “Corporate debt is coming, and it is nice to see that environmental, social and govern- ance concerns are having an impact and improving things. “And yes, there is uncertainty and risk, but that means you have to be selective about the manager you pick.”
June–July 2019 portfolio institutional roundtable: Emerging market debt 29
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