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Is emerging market debt worth the risk?

Fund managers are increasingly focusing on emerging market debt but is the asset class still too risky for mainstream investors, especially given the currency risk?

Last week, Schroders bolstered its fixed-income team with four managers from US firm ICE Canyon. In April, Standard Life appointed former Threadneedle head of emerging market debt Richard House and BlackRock recruited seven emerging market debt managers from BNP Paribas Investment Partners.

There has been growth in external corporate debt issued by emerging market companies over the past few years and emerging market debt has been opening up to foreign investors.

Currency fluctuations affect returns in emerging market debt and are viewed as a major contributor to the risk of the asset class.

According to Bestinvest senior investment adviser Adrian Lowcock, having some currency risk can benefit investors. He says: “In emerging market debt, most of the income comes from the bonds and the growth from the currency. A large part of the opportunity with the asset is around the long-term currency story, where emerging market currencies are expected to do well in the longer term. However, currency is volatile and clients should be aware of that.”

Investec Asset Management fixed income and currency strategist Thanos Papasavvas says the important thing for investors to realise is that returns can be made whether currencies rally or fall. He says: “We can generate returns when currencies are strengthening and when they are weakening so we see emerging market currencies as a relative value opportunity.”

Investec has moved towards higher-risk beta currencies this year across the £10bn emerging market debt range, including the £2bn Investec emerging markets local currency debt fund.

Papasavvas says: “During the risk-off period in Easter, we thought the sell-off was overdone and not reflective of the true underlying emerging market story so we took advantage of valuations and added risk into our emerging portfolios.

“This year, we bought the South African rand, the highest-beta currency in our benchmark, which was a good way to add risk into the portfolio. Last year, we had a short on the rand.”

The team also moved from an underweight to a neutral position in the Mexican peso in April.

JP Morgan international chief investment officer of fixed income Nick Gartside says he has chosen to add emerging market debt exposure in hard currency to the £462m JPM strategic bond fund.

He has introduced a 10 per cent emerging market debt exposure from a zero weighting in January this year.

He says: “Valuations on emerging market debt look attractive so we bought dollar-denominated emerging market debt. Assets compete with each other and when you look at a global universe, these bonds stand out in terms of valuation.”

Gartside says he bought the debt in dollars as there is a lot of volatility in emerging market currencies and he expects the dollar to strengthen this year.

In contrast, City Asset Management research director James Calder is avoiding emerging market debt exposure. He says: “We have taken the view at the moment that with emerging market debt the risk/return reward profile for us is not acceptable.”

“To look at emerging market debt, we need to see a return to a bull market, where there are strong GDP numbers across the globe and confidence returning to markets.”

Calder adds it is important that emerging market corporate debt funds have a presence on the ground in markets they invest in. He says: “In terms of investing in emerging market corporate debt, the risk then goes off the scale. You have to have managers on the ground looking at companies and this is where some teams will have more expertise than others.”

Top 10 emerging market bond funds

Return April 30, 2009 to April 30, 2012 (%)
£295m Invesco emerging markets bond 43.1
£187m Baillie Gifford emerging markets bond 30.0
£409m Capital International emerging market debt 28.4
£5.9bn Pictet emerging local currency debt 28.3
£2bn Investec emerging market local currency debt 28.2
£2.2bn BNY Mellon emerging market debt local currency 27.7
£574m HSBC GIF global emerging markets local debt 25.4
£742m Threadneedle emerging market bond 24.9
£21m M&G emerging markets bond 20.0
£76m Threadneedle emerging market local 15.0
Average return of emerging market bond funds 23.9

Data from Morningstar

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