Credit Suisse’s head of fixed income fund selection Omar Gadsby believes there is a powerful, long-term case to make for the asset class, especially on a relative basis, i.e. compared to developed market fixed income.
“We see the political premium in developed markets increasing from here as there is a lot of uncertainty around, especially post-Brexit,” he says. “Besides, EM represents only $5trn of the total $97trn of debt outstanding globally, while it delivers over 50% of global GDP growth,” he adds. “We are therefore overweight both local and hard currency debt.”
Gadsby hasn’t been the only investor piling into emerging market debt in recent months. Since March, the asset class had finally recovered from a post-Fed rate hike hangover, European fund buyers have piled in some €29bn into emerging market debt funds.
However, unlike Gadsby, most of these investors seem to favour the asset class for opportunistic, rather than strategic reasons. As you can see in the chart above, the correlation between the implied probability of a Fed rate hike and flows into EMD is striking.
Though EM corporates are issuing increasingly in local currency rather than dollars to overcome a mismatch between assets and liabilities, EM bonds remain sensitive to US monetary policy.
“The bulk of returns from emerging market bonds this year have come from moves in US Treasury yields. Duration risk is higher than credit risk as all moves have been in duration,” says Rashique Rahman, head of emerging market debt at Invesco.
From that perspective, it makes sense that European investors have been focusing on short-duration bonds this year. “I find it too risky to opt for long duration in hard currency emerging market debt,” says Bart van de Ven, a fund selector at the Belgian wealth manager Accuro.
Since the asset class is more volatile and more exposed to the effects of Fed monetary policy, the short-duration bias within emerging market debt is arguably even stronger than it is for developed markets, where investors have also reduced duration in response to flattening yield curves.
Play it hard or play it local?
However, as far as the choice between hard and local currency is concerned, opinions are divided. According to Expert Investor data, EM (mainly local currency) government bonds and EM (mainly hard currency) corporate bonds are both equally in demand. Over three quarters of European fund buyers have exposure to either, and more than one in three intend to increase their allocation over the next 12 months.