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Funds for Tapping Into Emerging Market Debt

For investors aware of the associated risks, there are plenty of opportunities to benefit from the exceptional absolute returns delivered by emerging market debt funds

Emma O'Neill 28 January, 2013 | 9:52AM

Norway’s sovereign wealth fund, the world’s largest with around $660 billion in assets, made its first ever allocation to emerging market debt (EMD) in 2012. This is emblematic of the huge interest the asset class has received over the last year. JP Morgan even declared 2012 as the year that EMD “came of age” and cemented its position as a mainstream investment-grade asset class. 

Indeed such is the interest in the asset class that Slovenia, a eurozone member, (after failing to sell a euro-denominated bond earlier this year) turned to the deep-pocketed EMD market by issuing its first dollar-denominated bond since 1996. Despite the country battling a domestic banking crisis this bond was snapped up, mostly by EMD funds, underlining the huge demand for bonds of the developing world.  

EMD Rewards Investors in 2012

Investors in the sector were handsomely rewarded in 2012 as absolute returns have been exceptional, outpacing traditional fixed income sectors and even riskier equity markets. Investors have been lured by the comparatively high returns and an increasing perception of diminishing risks. The fundamentals certainly look compelling as emerging countries have witnessed significantly higher economic growth over the previous decade compared with industrial countries. 

Over the last few years government balance sheets have also improved significantly in contrast to developed countries. Furthermore, policy frameworks have been enhanced and most emerging markets countries have adopted inflation targeting and more flexible exchange rates. This improvement in quality is also indicated by the convergence of the credit ratings between developed and emerging market countries. 

Supporting Factors 

The technical factors also appear supportive. Overall, the technical backdrop for fixed income products in 2012 was positively fuelled by a lack of supply in USD-denominated spread products and amplified by the main central banks continuing with their quantitative easing policies. With yields on emerging market debt above developed government debt, as well as US and European investment grade debt, it is easy to see why so many investors have been attracted to the sector. Should central banks continue with their quantitative easing policies this year it is likely the shortage of spread products will continue through 2013, further fuelling demand.

Proponents of the sector also highlight that most institutional investors are still grievously under-allocated to the asset class and predict that funds such as Norway’s sovereign wealth fund, along with insurers and endowments, will continue to increase their weightings as they seek alternatives to troubled western economies. 

Associated Risks 

However, investors should remember that at times of market stress, such as those experienced in the third quarter of 2011 and also over 2008, the asset class has delivered sharp negative returns. For instance, in September 2011 alone the average hard currency bond fund fell 7% (in USD) and this loss was amplified in the local currency bond market with the average fund losing investors 10% over the month. 

Liquidity risk has always been a significant factor for EMD funds and this potential risk has been exacerbated by the significant inflows the sector has received since the beginning of 2009. The reversal of these inflows was generally regarded as a key pressure point for the asset class and in the third quarter last year we witnessed the extent to which it can impact performance. In particular, EMD denominated in local currencies may be more susceptible to outflows if another flight to quality takes hold and this will be particularly notable for those countries with high levels of foreign ownership, such as Hungary. Coupled with this, political risks also remain high in many of these countries—the political wrangling surrounding the Argentinian debt and the unrest in the Middle East are timely reminders of such risks. 

Nonetheless, as long as investors understand the potential risks, the sector offers many attractive fundamental attributes and the technicals are likely to remain supportive in the short term as yields on developed market government bonds remain artificially low and the developed world continues to lurch from one crisis to another. 

Funds for Tapping into EMD

So what funds are available to investors? The composition of the market has markedly changed over the last decade as emerging market local bonds now account for a much larger portion of the market compared to emerging market hard currency bonds. The trend for emerging countries to switch from US dollar issuance to local currency bonds has accelerated since 2005. Local currency bond funds offer investors exposure to interest rate convergence between developed and developing world countries in addition to the potential for upside from the currency exposure. However, this can lead to a more volatile performance profile relative to hard currency bond funds. 

Within hard currency issuance the market composition has also evolved with significant growth in the issuance of corporate and quasi-sovereigns over the last ten years. Indeed, the total value of the emerging market corporate debt market recently hit the $1 trillion mark and is approaching the value of the US high yield bond market. For those investors who are attracted to the sector but are unsure about which part of the market to invest in, a flexible fund (which invests across the sector) may be attractive as the asset allocation decisions are made by the fund manager. 

Among the Largest... 

The ten largest funds on this list have substantial assets under management, with all funds holding over $2 billion. The concentration of assets in such a small group of funds indicates the limited number of viable offerings within the asset class, which is similar to what we see in the emerging market equity sector.

The largest fund on the list is the Templeton Emerging Market Bond fund (rated Silver by Morningstar OBSR analysts), which offers investors a blended approach to the asset class, investing in both local currency and US dollar-denominated debt. The fund is run by Michael Hasenstab who has been involved in the fund’s management since 2002 and became lead manager in 2006. We like the manager’s long-term strategic approach to fixed income, which relies on detailed macroeconomic fundamental analysis to position the fund in the parts of the global universe that he believes offer the best value.

MFS Meridian Emerging Market Debt (rated Bronze) offers investors a predominantly US dollar-denominated sovereign debt fund. We hold this fund in high regard and particularly like the team's risk-aware approach, which is underpinned by a clear mindfulness on capital preservation though they are nevertheless willing to take meaningful risks when they are deemed to be appropriate.

For investors seeking emerging market corporate bond exposure, Bluebay Emerging Market Corporate Bond is one of the largest corporate bond EMD funds in the market and has witnessed significant inflows since its 2008 launch. Bluebay is a specialised bond asset manager that has significant resources across the asset class. The fund is managed by Polina Kurdyavko, who adopts a flexible and total return approach (similar to other Bluebay products).

Among the Top Performers...

The funds on the best performers list have not only delivered exceptionally strong returns relative to peers but also relative to other sectors.

The top performing fund is the GMO Emerging Country Debt Investment fund but with the minimum investment for this share class a hefty $5 million, it’s inaccessible to most private investors.

Elsewhere, the largest fund on the list is the HSBC Global Emerging Markets bond fund, another hard-currency EMD fund that is managed by Guillermo Osses, who joined from PIMCO in 2011 to head up the team. This fund alone has over $4 billion and in total the team manage around $9.7 billion across a number of strategies. A portion of the fund’s track record, however, can be attributed to the previous manager, Denise Simon, who managed the fund from 2005 until April 2010 when she left to join Lazard.

Another top performer is Aberdeen Global Select Emerging Market Bond fund, run by Brett Diment. The Aberdeen team covers the spectrum of hard currency, local currency and corporate bonds, with a primary emphasis on hard currency but significant flexibility to capitalise elsewhere when appropriate. 

 

Use Morningstar’s Fund Screener to find more EMD funds that meet your chosen criteria.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Emma O'Neill

Emma O'Neill  is a fund analyst with Morningstar OBSR.