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Back to basics: a quick guide to emerging market debt

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27/11/2013
Most investors will be familiar with emerging market (EM) equity funds but these are not the only way to tap into the EM growth story.

Thanks to a flurry of new fund launches, the emerging market debt (EMD) asset class has become more accessible to UK retail investors.

What is emerging market debt?

Emerging market debt is a term used to encompass bonds issued by governments and corporates in developing countries.

Until the 1990s, emerging market debt was a fairly limited fixed income asset class consisting primarily of government bonds issued in hard or major currencies, typically the US dollar but also sterling, euro or yen.

Over the years, the asset class has developed and matured to include a wide variety of government and corporate bonds, issued in local currency (often referred to as “emerging local markets bonds”) as well as major currencies.

According to Aviva Investors, the hard and local currency emerging market bond market is now five times the size it was a decade ago and more than nine times what it was back in 2001.

Emerging market bonds are considered as being relatively high risk because of the dangers associated with countries with fairly nascent financial markets.

What are they different types of EMD?

EM government bonds

EM government bonds tend to be denominated in major currencies like dollar or sterling and are considered the most mature type of emerging market debt.

EM sovereigns tended to issue in external currencies to attract international investors who did not want to accept local currency risk.

But as the market matured and investors grew more confident, EM governments started to issue bonds in local currencies.

Investors should note that due to the export led nature of many developing countries, there is a heightened risk of currency depreciation, which might affect the value of their investment, as government economic policies might be tailored to prevent the appreciation of their local currency.

For investors considering government emerging market debt, they should bear in mind that it is much easier to exit if they opt for developed-market currency bonds instead of local currencies.

EM corporate bonds

As the name suggests, EM corporate bonds refer to the debt issued by corporations in developing markets.

While this asset class is growing, investors should remember that transparency, corporate governance and accountancy standards of companies in EMs may lag developed markets.

There are also heightened concerns over bankruptcies and volatility.

Hard or local currency?

Today over 60% of the EMD hard currency universe is rated investment grade and there are many new candidates for upgrades emerging.

There are also hundreds of different bonds available across countries and industry sectors and investor demand remains strong.

Compare this to the only 17 countries currently issuing local currency EMD, according to Aviva Investors, and credit and currency risks are naturally higher.

However, local currency debt allows investors to capitalise on the economic growth of developing markets.

The choice will come down to the individual investor’s risk profile.

EM debt versus EM equities?

According to Grant Webster, portfolio manager at Investec Asset Management, when you access EM debt over EM equities you are accessing entirely different spheres of the emerging market investment universe.

Investors of EM debt get access to the macroeconomic side of these economies – like inflation targeting and the fiscal policies to get these economies growing, whereas with EM equities you tap into the consumer side – like growing middle classes and young demographics.

Which funds?

Some fund picks from the experts…

Investec Emerging Market Blended Debt fund – this fund gives investors a mix of local currency and hard currency debt as well as corporate bonds and sovereigns.

Schroder ISF Emerging Markets Debt Absolute Return – This fund invests in bonds issued by emerging market governments and corporations, with a blended approach. The team aim to achieve an average annualised return of 10% a year over the long term and for a positive return over any 12-month period. 

For investors who want a more global bond investment…

Templeton Global Bond – This fund offers a global exposure to fixed interest and currently has a distinct bias towards the debt of emerging market governments. The manager, Dr Michael Hasenstab, takes concentrated bets on his favoured countries and so the fund has the potential to be volatile.

 

 

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