Emerging markets debt is attracting investors again

Emerging markets debt, pummeled during last year's “taper tantrum,” is now tempting institutional investors back into the fold.

Compelling valuations are the driving factor, but the move is also a long-term strategic bet that certain emerging economies likely will outperform developed markets, consultants said.

“Emerging markets debt is one of the most popular asset classes right now,” said Phil Edwards, principal and European director of strategic research at Mercer in Bristol, England. “Investors want access to the growth dynamics of (emerging) countries, the long-term appreciation of their currencies and the lower levels of debt relative to developed economies.”

But institutions remain wary of emerging markets volatility. On July 17, after the downing of Malaysia Airlines Flight MH17 over Ukraine combined with the U.S. expansion of sanctions on Russia roiled markets, Russian 10-year sovereign bond yields jumped by 33 basis points to close at 9.01%. (Bond prices fall when yields rise.)

Among those increasing active emerging markets debt exposure are the world's two largest pension funds.

Japan's ¥126.6 trillion ($1.25 trillion) Government Pension Investment Fund, Tokyo, is searching for EMD managers to run an undisclosed sum of assets.

Norway's 5.1 trillion Norwegian kroner ($823 billion) Government Pension Fund Global, Oslo, recently hired Templeton Asset Management and Pacific Investment Management Co. to run its first dedicated EMD strategy. Both portfolios amounted to less than 0.1% of total assets, and officials likely will add to that position, according to the fund's 2014-2016 investment strategy report published in June.

Others that have increased allocations to active emerging markets debt this year include: Ohio Public Employees' Retirement System, Columbus, which oversees about $75 billion in defined benefit assets; the $16.6 billion Illinois State Universities Retirement System, Champaign; the £2.8 billion ($4.8 billion) Leicestershire County Council Pension Fund, Leicestershire, England; and the $2.7 billion Louisiana Sheriffs' Pension & Relief Fund and $1.8 billion Louisiana Municipal Police Employees' Retirement System, both in Baton Rouge.

In the first half of 2014, emerging market debt drew about $107 billion, accounting for 70% of the total inflows into emerging markets, according to data provided by the Institute of International Finance, Washington.

Emerging market debt flows industry wide have been positive for 14 straight weeks so far this year compared to net outflows for 40 out of 43 weeks between May 2013 and February 2014. “Emerging markets have calmed down, and the risk/reward tradeoff is starting to look very good,” said Michael Gomez, managing director and head of the emerging markets portfolio management team at PIMCO, which runs about $100 billion in emerging markets debt.

Investor trepidation has largely subsided over the pace of the Fed's tapering, slow growth in China, the Ukraine crisis and election cycles in major markets such as India, Turkey, Indonesia and Brazil. Furthermore, valuations are at a level that provides “a little bit of cushion” in a rising interest rate environment, Mr. Gomez said.

“Emerging markets debt used to be much more dominated by hedge funds and retail investors,” said Kristin Ceva, managing principal and head of emerging market debt strategies at Payden & Rygel, Los Angeles “Now, about 80% of the (investible) assets are owned by institutions” such as pension funds, sovereign wealth funds and insurance companies.

Compared to emerging markets equities, greater cash-flow certainty in EMD has helped to dampen volatility, Ms. Ceva said. The Sharpe ratio, a measure of risk-adjusted returns, for the J.P. Morgan EMBI Global Diversified index is around 0.88 compared to 0.33 for the MSCI Emerging Markets index between Dec. 31, 2002, and May 31, 2014.

In the summer of 2013, many institutional investors put plans to invest in the asset class “on the shelf,” said James Barrineau, co-head of emerging markets debt relative at Schroders PLC in New York.

“Now they're coming back,” Mr. Barrineau said. “In the global search for yield, (emerging markets debt) is one of the last asset classes standing where investors can get some decent yield.”

The Louisiana sheriffs' fund is among those that delayed implementing an emerging markets debt strategy last year but has since taken its first step. “There was a lot of noise about emerging markets and we weren't sure where the asset class was heading,” said Osey “Skip” McGee Jr., executive director.

“We're not taking a big bet,” Mr. McGee said, referring to the $25 million active emerging markets debt strategy awarded to Ashmore Investment Management in June.

While hard currency sovereign bonds generally fared better through the recent turmoil, managers see more opportunities in certain emerging high-yield bonds, which are trading at more than a 6% yield. In comparison, similarly rated U.S. high-yield bonds are averaging about 5% and eurozone high-yield, about 4%.

“A lot of clients are shifting into emerging markets corporate debt from (developed markets) high yield,” said Margaret Frost, head of generalist portfolio management at London-based Rogge Global Partners, which manages about $8 billion in emerging markets debt assets.

Unlike developed market high-yield bonds, however, investing in emerging market corporate bonds “has to be underpinned by an improving and stable sovereign story,” added Michael Ganske, head of emerging markets at Rogge.

Investment-grade emerging markets sovereign bonds also are trading at considerably higher yields than lower — or similarly rated — government bonds in developed markets. For example, Mexico's 10-year government bonds, which are rated BBB+ by Standard & Poor's, are yielding about 5.6%. In comparison, Spain's BBB 10-year bonds are trading at 2.7%, only a sliver higher than the 10-year U.S. Treasury yield of 2.5% as of July 17.

Colin Pratt, investment manager at the Leicestershire County fund, said officials expect to hire their first dedicated emerging market debt manager later this year to run a £70 million portfolio.

“Emerging markets debt has evolved so that there's now sufficient depth and liquidity,” Mr. Pratt said.

While more emerging markets sovereign debt has been upgraded since the 2008-2009 financial crisis, with at least 70% classed as investment grade, many developed government bonds have been downgraded since the crisis. “This has led to a huge convergence” that hasn't yet been adequately reflected in institutional portfolios, said Rob Drijkoningen, managing director and co-head of emerging markets debt at Neuberger Berman based in The Hague, Netherlands.

At the same time, emerging economies are diverging. Brett Diment, head of emerging markets debtat Aberdeen AM based in London, said the investment universe comprises more than 70 countries. “What's driving Mexico is very different from what's driving Ukraine,” said Mr. Diment, whose firm had £6.9 billion ($11.8 billion) in EMD as of March 31.

“Country differences have always been important in emerging markets debt, but they're especially important going forward.”