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New Markets, New Opportunities, and New Risks for EM Fixed Income Investors
As the global economy confronts the fallout from the Covid-19 pandemic and a sustained war in Europe, fixed income investors look to emerging markets for diversification, ESG performance, and higher yields. Their enthusiasm for EM fixed income is tempered by concern about debt loads, illiquidity, and market volatility. Nonetheless, nearly two out of three investors anticipate increasing their EM fixed income allocation, according to new research from Vontobel and II’s Custom Research Lab.
As inflation, interest rate hikes, and the prospect of an economic slowdown loom overhead, investors in a recent study say they’re likely to look to emerging markets as a source of stable fixed income returns. A solid majority of survey respondents say they’re likely to increase their overall allocations to emerging market fixed income, as shown below. Those increasing their EM fixed income allocations are driven to the asset class by the diversification benefits of EM fixed income available through liquid markets in which assets are readily available.
Investors are most likely to increase their holdings of EM corporate bonds rather than EM sovereign issues in the next two years, according to survey data. The appeal of EM corporate fixed income, say sources, is tied in large part to their focus on the measurable commercial activity of an enterprise, rather than on the broader performance of an entire emerging market economy. “If we’re looking at a fund that’s just municipal or government bonds, it’s clear that, yes, this is one way to get exposure,” say a fixed income manager at a US life insurer. “But if the mining industry is booming in this country, and it’s rich in minerals or resources – or if the country is having a huge tech boom like India – we want to capitalize on it. We don’t want something else dragging the investment down, since we’re already taking a risk by investing in it.”
The head of pension investments at a Swiss pension says it holds several hundred million Swiss francs in emerging market debt, primarily through corporate bonds and “semi-sovereign” bonds issued by state-owned entities. “We look most closely at yield to maturity,” he says. “Minus hedging costs from the US dollar to the Swiss franc – we hold only hard currency bonds – we see a positive yield to maturity.” His institution holds its EM fixed income sleeve through an actively managed fund linked to its risk/return benchmark and depends on its EM fixed income manager to make buy and sell decisions.
These and other examples of analytically savvy investments illustrate both the opportunity for solid returns and diversification from investing in emerging market fixed income and the risk of doing so. Emerging markets are inherently riskier than developed markets. These markets are culturally and geographically distant from investors and their managers in developed markets. Their investment and legal infrastructure is less fully developed, or at least foreign. In some cases, corruption is widespread and is treated more as a cost of doing business than as a crime. Accordingly, the rewards of EM fixed income investment are tempered by the manifold risks – some transparent, others opaque – of such markets and asset classes.
Emerging market fixed income offers investors an opportunity to offset portfolio risk in their non-EM holdings, and to direct their capital toward income-generating assets that are aligned with their ESG objectives. They’re held back, however, by asset-specific concerns such as debt loads and default risk and the quality of data available for making investment decisions. Market factors such as liquidity and volatility are top of mind among investors as well.
This article is adapted from the research report, Institutions Look to Emerging Market Fixed Income for Yield, Diversification, and ESG Alignment, published by Vontobel Asset Management and II’s Custom Research Lab in May 2022. The study includes survey data from more than 300 asset-owning institutions worldwide and interviews with ten investment decision makers at such institutions. Click here to download the full report www.vontobel.com/fi2022.
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