Markets & Economy

Multi-Asset Investing

Emerging Market Debt – An Asset Allocation Perspective

June 1, 2018
Emerging market debt can fulfill a wide array of roles, including dampening risk, boosting income, and as a return-seeking growth asset.

Key Points

  • Emerging market debt (EMD) can play three main roles in a multi-asset portfolio: income, growth, and diversification versus equities and developed market debt.
  • Blending different types of EMD offers the chance to generate excess return through security selection and dynamic allocation across segments.
  • We believe there is a case for maintaining both strategic and tactical allocations to EMD.

INTRODUCTION

Emerging market debt (EMD) has come to play an increasing role in multi-asset portfolios, not least because it offers the opportunity for higher income in a low-yield world. But the thing to remember is that EMD is not a single homogeneous asset class. It spans several types, each with its own set of risks and return opportunities. Investors can use EMD to fulfill a wide array of roles in portfolios, including a source of income, a risk-dampening diversifier, and a return-seeking growth asset.

Commonly, EMD is split into three subsets, or sectors:

  1. Hard currency sovereign debt, issued by governments of emerging market (EM) countries but denominated in currencies of developed market (DM) countries, most commonly the U.S. dollar.
  2. Hard currency corporate debt, issued by companies operating in EM countries and predominantly dollar denominated.
  3. Local currency sovereign debt, government related, issued in the currency of the issuing country.

It is useful to look at the sources of return and risk of each EMD subset to understand its characteristics and the potential roles it can play in portfolios. Figure 1 maps the three sectors according to the three broad sources of return and risk of fixed income assets:

  1. Interest rate risk or duration risk: sensitivity to changes in interest rates.
  2. Credit risk or default risk: inability of issuer to repay its debt obligation.
  3. Currency risk: sensitivity to fluctuations in value of currency of denomination relative to the investor’s base currency.

THE ROLE OF EMD IN MULTI-ASSET PORTFOLIOS

For asset allocators looking to identify the appropriate role of any asset class in a portfolio, one starting point is to define the opportunity as either a risk asset or a conservative asset. The typical role of risk assets (return-seeking or growth assets), including equities and high yield bonds, is to generate inflation-beating growth and potentially high levels of income. The typical roles of conservative assets, such as DM government bonds and cash, are to generate steady income, diversify against portfolio volatility caused by risk assets, hedge liabilities, and potentially generate positive returns when risk assets fall.

While EMD is a fixed income investment, it is actually a risk asset. As Figure 2 demonstrates, the volatilities of the different subsets of EMD are closer to equities than global investment-grade (IG) bonds; EMD has historically experienced declines, or drawdowns, of 20% or more; and its total return has been higher than that of IG bonds. However, because of its fixed income cash flow characteristics, EMD can also fulfill the role of a diversifier in multi-asset portfolios.

AN EVOLVING ASSET CLASS

One thing worth noting about the historical drawdown numbers is that EMD risk profiles have changed over time. For example, while in the early 1990s the representative EMD hard currency index, the J.P. Morgan EMBI Global Diversified Composite, was light on IG issuers—today about 50% of the index is investment grade and 50% high yield. This change in the mix impacts not only the credit risk, but also the interest rate risk and volatility of the asset class. Bonds with low credit ratings tend to be more volatile but less sensitive to changes in interest rates than high-rated bonds. The changes in the credit quality of the index over the years means that it has become less volatile and it has less severe drawdowns, but its correlation with DM investment-grade sovereign bonds has increased.

Figure 3 shows the drawdowns of EMD hard currency, global equities, and global IG bonds. EMD suffered more severe drawdowns than those of global equities in the 1990s, but equities’ drawdowns dwarfed those of EMD in the 2000s. However, as expected, both EMD hard currency and global equities had more severe drawdowns than developed market IG bonds.

INCOME FROM EMD

Figure 4 compares the yields of EM hard currency governments and corporates with those of 10-year U.S. Treasuries and global IG bonds. EMD has been a source of high levels of income, particularly since the 2008 global financial crisis, after which yields of DM bonds fell due to quantitative easing (QE) and super-accommodative monetary policies. Yields of EMD have come down, but not as much as those of DM issuers.

REAL GROWTH

As shown earlier in Figure 2, EMD can deliver attractive total returns. Total return is composed of two components: income and capital gains. In EMD, income can account for a high proportion of total return. However, as rates in some EM countries are high relative to those in DM countries, the scope for future capital gains is still there. In addition, given today’s rich valuations for almost all the major asset classes and a generally low-yield environment, the importance of income in total returns might increase, meaning EMD may have an advantage over asset classes, which rely more on capital gains.

DIVERSIFICATION

EMD can play a unique role in multi-asset portfolios by diversifying not only equity risk, but also the risk of conservative assets, such as DM government bonds. If rates rise, traditional conservative assets might experience losses. In this scenario, diversifying interest rate risk becomes important. Figure 5 shows the correlations between the subsets of EMD and global equities and IG bonds since 2003. Not only is the correlation between EMD and equities imperfect, but the correlation of EMD with IG bonds is low, also offering diversification benefits. EMD is more correlated with equities than it is with IG bonds, which may be advantageous in a rising rate environment.

HOW TO INVEST IN EMERGING MARKETS DEBT—A MULTI-ASSET PERSPECTIVE

For a multi-asset investor, the strategic decision of how much to allocate to EMD in a portfolio depends on several considerations, such as the outcome the portfolio aims to achieve, the investor’s risk tolerance and the role EMD needs to play within the portfolio. When allocating to EMD, investors should take account for the risks as well as the expected benefits.

THE BENEFITS OF ACTIVE MANAGEMENT

EMD is an asset class where an active approach is recommended for several reasons. First, in a more diverse market compared with DM debt, there are significant opportunities for a skilled portfolio manager to generate excess return above benchmark (alpha) through security selection. Second, from a risk-management perspective, investors should seek a skilled portfolio manager with a proven fundamental credit research track record to avoid lending to issuers that might default. Finally, in EMD local currency, skilled active currency management is crucial both to add excess returns and manage risks.

The shortcoming of passive management (e.g., passive index tracking strategies) is not just the loss of the opportunity to earn alpha. From a risk perspective, the biggest negative event for the asset class would be a debt default, and for that investors require a process to identify defaults before they arise. This requires the informed approach offered by active investing.

EMD offers potential rewards to investors in the form of potentially attractive income, potential for growth, and diversification of risks of both equity markets and DM government bonds, as well as opportunities for alpha generation from skilled active management.

BLENDING THE SUBSETS OF EMD

Blending the three different flavors of EMD can create a portfolio with a wide investment opportunity set, reduced risk given the imperfect correlations among subsets of EMD, and opportunities to allocate tactically among the sectors based on their attractiveness.

Figure 6 shows the rolling 12-month performance of each of the EMD subsets, as well as a blend investing 1/3 in each one. The blend demonstrated steadier performance over time. Of course, this is just a static allocation among passive indices, so it does not account for any potential benefits from active security selection or tactical asset allocation, and it does not reflect any transaction costs and charges associated with passive and active management.

CONCLUSIONS

EMD offers potential rewards to investors in the form of potentially attractive income, potential for growth, and diversification of risks of both equity markets and DM government bonds, as well as opportunities for alpha generation from skilled active management. Investors should consider including it in their multi-asset portfolios, especially in the current low-risk environment and richer valuations of many other asset classes.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of April 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. International securities tend to be more volatile and less liquid than investments in U.S. securities and may lose value because of adverse local, political, social, or economic developments overseas, or due to changes in the exchange rates between foreign currencies and the U.S. dollar. The risks of international investing are heightened for securities of issuers in emerging market countries. Emerging market countries tend to have economic structures that are less diverse and mature, and political systems that are less stable, than those of developed countries. In addition, there are interest rate and credit risks normally associated with investing in bonds. All charts and tables are shown for illustrative purposes only. It is not possible to invest directly in an index.

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