Investors sticking with emerging markets debt

Institutional investors are still turning to emerging markets debt for higher yields, despite downgrades on Russian sovereign and corporate bonds that forced some indexes to remove certain bonds.

At the end of February, Barclays PLC removed 11 Russian sovereign and more than 35 corporate bonds from its indexes after rating agencies downgraded the bonds to junk status.

Even so, the appetite for emerging markets debt is still evident.

The current low-interest-rate environment is “creating a demand for yield, which emerging markets debt should benefit from,” said Gorky Urquieta, co-head of emerging markets debt and a portfolio manager at Neuberger Berman Group LLC.

Mr. Uriqueta said the pipeline of emerging market debt searches seems “pretty healthy,” noting its blended strategy of sovereign, quasi-sovereign and corporate bonds in local and hard currencies is the most popular of the five it offers. Neuberger managed $4.1 billion in emerging markets debt assets as of Jan. 31.

Among those currently searching for emerging market debt managers are the $29.4 billion Connecticut Retirement Plans & Trust Funds, Hartford; $1.9 billion Chicago Transit Authority Employees Retirement Plan; and $1.1 billion Cambridge (Mass.) Retirement System.

Over the course of 2014, eVestment's emerging markets debt universe experienced $16.3 billion in total net outflows. Results varied among the various investor types. For example, pension funds poured a net $4.8 billion into emerging markets debt strategies while sovereign wealth funds withdrew a net $11 billion, according to eVestment LLC, Marietta, Ga.

Separately, The Institute of International Finance, Washington, reported February inflows of about $6 billion into emerging market debt, down from $14 billion in January but up from a $7.8 billion net outlflows in December.

Lucinda Downing, senior asset allocation analyst at Aon Hewitt in London, said emerging markets bond yields are attractive. The firm's consultant are encouraging clients with small allocations to increase them by investing in a blend of local and hard currency bonds.

The $14.4 billion New Mexico Public Employees Retirement System, Santa Fe, in October began a search for its first emerging markets debt managers as part of a new 5% allocation to fixed-income plus, which includes emerging markets debt.

The managers will be permitted to make a range of investments, including corporates, sovereigns, quasi-sovereigns and derivatives. “To the extent there are dislocations and corrections prior to the launch of a manger, is favorable for us. It could potentially make investments cheaper,” said Jonathan Grabel, chief investment officer.

The £2.8 billion ($4.3 billion) Leicestershire County Council Pension Fund, Leicester, England, has roughly £45 million invested with Ashmore Investment Management Ltd. in a pooled emerging markets debt fund. With the intended exposure at roughly £70 million, there is still significant capital to deploy, Colin Pratt, investment manager, said in an e-mail. Mr. Pratt said he sees the “recent market falls as an excellent entry opportunity.”

While concerns have been raised over weak emerging currency performance, Ms. Downing recommends clients “see through the recent weakness and take more of a medium- or longer-term view of starting to build exposure” to the asset class.

Ms. Downing said search activity picked up in the last year or two from a “low base.” In the last year, Aon Hewitt assisted with about 10 searches.

Performance concerns could be influencing search activity, Ms. Downing said.

In February, the emerging markets hard currency universe returned 0.85% and local currency returned -1.34%, said a report from Ashmore.

For the year ended Dec. 31, J.P Morgan's Emerging Market Index Global Diversified returned 7.43%. One-year returns for the JP Morgan Corporate Emerging Markets Diversified and JPM GBI-EM Diversified Unhedged indexes were much lower at -2.68% and -8.5%, respectively.

In the medium term, Ms. Downing expects “higher yields will compensate investors for short-term currency (moves).”

Expected returns on emerging markets debt are attractive over the long term, agreed Randy Wedding, senior managing director, fixed income, at the University of California, Oakland. Negative interest rates in Europe and the European Central Bank's quantitative easing program have depressed yields on European debt.

The university has about $1.5 billion invested in U.S. dollar-denominated emerging markets debt across its $52 billion pension and $8 billion endowment portfolios. Its benchmark, the J.P. Morgan Emerging Markets Bond Index Global Diversified, contains both investment grade and non-investment grade bonds. The university is permitted to hold both.

Seth Bancroft, a research analyst at consulting firm NEPC LLC, Boston, believes emerging markets debt is a good investment for clients. “If clients have a target weight to EMD in their portfolio, we are recommending that they keep that and not reduce it,” Mr. Bancroft said.

Outside of a “few rare instances,” clients are not pulling out, Mr. Bancroft said.

“In the long term, secular drivers in emerging markets still hold,” said Phillip R. Nelson, director of asset allocation at NEPC. “There are better growth prospects (there).”

Jan Dehn, London-based head of research at Ashmore, said credit ratings play “no direct role” in the firm's investment strategy.

“We have had big changes in global sentiment, including volatile U.S. growth, commodity price movements, a stronger dollar and the usual concerns over Greece. Japan has also aggressively manipulated its currency weaker over the past 12 months. These drivers have had a big impact on emerging market asset prices, but very little effect on emerging market fundamentals,” Mr. Dehn said in an e-mail. “The result is that emerging markets are quite attractively priced.”

With the exception of the Emerging Markets Investment Grade Bond Fund, the majority of J.P. Morgan's Asset Management's dedicated emerging market debt strategies are not constrained by ratings, said Zsolt Papp, London-based client portfolio manager on the emerging markets debt team at J.P. Morgan.

Mr. Papp said portfolio managers aim to be proactive, rather than reactive, on ratings.

“Often the bond market anticipates rating actions on information such as earning reports, corporate events, or economic developments. Our analysts would look at valuations, fundamentals and technicals of such an issuer and based on this, the portfolio mangers would decide any subsequent trading action,” Mr. Papp said in an e-mail.

Valuations, liquidity and supply vs. demand are currently favoring sovereign bonds over corporate bonds, Mr. Papp added. However, corporate valuations have become more attractive in recent weeks, he acknowledged.

Arleen Jacobius contributed to this story.