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Do we really need an emerging market debt sector?

After a flurry of launches, a new sector dedicated to emerging market debt funds seemed a good idea. But has the IMA been too hasty?

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The Investment Management Association plans to create an emerging market bond sector following a flurry of launches but just as investor sentiment seems to be turning away from the asset class.  

The IMA Global Emerging Markets Bond sector will be created on 31 December 2013 and be home to funds with at least 80 per cent of their assets invested in emerging market bonds as defined by a recognised emerging markets bond index.

However, the emerging market debt space has experienced significant outflows in the past few months. With the fallout of Ben Bernanke’s “tapering” announcement and fears over a slowing China, investors have pulled money from asset classes they deemed riskier and EMD fell victim to this sentiment.

Investec Asset Management portfolio manager and co-head of the firm’s EMD team Peter Eerdmans says that, taking a longer-term view, EMD will be back in favour and that underlying factors in support of the asset class remain unchanged.

Eerdmans says: “While at times, such as the recent sell-off, the markets may react with nervousness to changing dynamics, overall we believe the superior long-term growth potential in emerging markets will allow them as a whole to attract more than sufficient capital, underpinning asset prices.

“Looking to EMD, we believe that with relatively low duration and a high starting yield, local EMD offers protection, especially in case of a gradual move higher in yields.”

Chase de Vere head of communications Patrick Connolly is unsurprised that the IMA has given the asset class its own sector but is still dissuaded from guiding clients towards it.

Connolly says: “There have been an increasing amount of EMD funds launched in the past few years. It makes sense that advisers are able to look at them like for like.

“That said, we do not use EMD portfolios. I guess the overriding thought is that with fixed income [the IMA] are trying to adapt sectors according to what is happening out there. The intention is good.”

Hargreaves Lansdown senior investment manager Adrian Lowcock is also sceptical of EMD opportunities. He suggests that not many of the funds in this soon-to-be created sector stand out.

Lowcock says: “I think this whole area got a bit frothy at the beginning of the year. And since then there has really been a swaying back to developed markets. At the end of the day, you need to look at potential returns and what potential capital appreciation possible on top of that. Income levels came down and you were not getting compensated for the risk.”

Bestinvest managing director of business development and communications Jason Hollands also does not recommend EMD products, feeling they are better suited to institutional mandates rather than retail. Hollands says: “We do not tend to use them. The concern is that you take on a lot of currency risk.”

Hollands is also sceptical of the IMA creating a new sector for EMD funds off the back of the flurry of launch activity. However, Hollands does recommend Eerdman’s £1.9bn Investec Emerging Markets Local Currency Debt fund.

Regarding the new EMD products coming to market, Hollands adds: “I am slightly nervous that it could be a fad. The industry has a bad history of launching things at the wrong time.”

Rathbones bond fund manager Bryn Jones is bearish on EMD, having trimmed his exposure to the asset class at the beginning of the year due to high volatility and a lower yield than other asset classes such as UK investment grade. This sentiment has remained the same and Jones says: “We will still see negative flows as you are not being compensated for the risk.”

Jones sees improving economies in developed nations as having an adverse affect on EMD. Jones, who is bullish on the highly-touted US recovery, says: “As a result of that it will take away from emerging market companies and have a knock on affect for their economies. Also investors need to be aware of currency risk – there are huge differences in returns when it comes to currencies.”

With investors more risk-conscious than ever before, EMD is proving to be a hard sell and investors have pulled significant sums from the asset class. There is plenty of concern that forecast recoveries in developed markets benefiting from proactive central bank policy will have a negative impact.  

Equilibrium Asset Management investment manager Mike Deverell shares concerns about the risk and volatility associated with EMD andprefers to pass the decisions onto strategic bond managers to make calls on exposure to this asset class. Deverell says: “We will take a view, but for most of our clients we would not go for EMD because the risk is too much.

“We prefer to use strategic bonds, so they can decide on how much EMD to use. We use the £1.4bn Jupiter Strategic Bond fund, which probably has a small amount of EMD exposure within it.”

Other strategic bond funds Deverell highlights are the £268m Invesco Perpetual Tactical Bond fund, the £616m JP Morgan Strategic Bond fund and the £127m TwentyFour Asset Management Dynamic Bond fund.

The 10 largest EMD funds

Fund Size
Templeton Emerging Markets Bond £5.4bn
Pimco GIS Emerging Local Bond £5bn
Pimco GIS Emerging Markets Bond £4.1bn
Pictet Global Emerging Debt £3.3bn
MFS Meridian Emerging Markets Debt £2.7bn
BNY Mellon Emerging Market Debt Local Currency £2.4bn
Investec Emerging Markets Local Currency Debt £1.9bn
Pimco GIS Emerging Markets Corporate Bond £1.3bn
Threadneedle Emerging Market Bond £798m
Baillie Gifford Emerging Markets Bond £537m

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Comments

There is one comment at the moment, we would love to hear your opinion too.

  1. EMD probably makes sense for the majority of investors. The article addresses several concerns, but doesn’t differentiate enough between funds that invest in USD bonds (no currency risk) and those that invest in local currency bonds. There are plenty of options in either style, but they are distinctly different. Also, many USD bond funds have existed for 15-20 years, so while new funds may appear as a fad, the industry has a fairly long track record.
    Don’t forget that when you choose not to invest in EMD, you are choosing to ignore debt markets from countries that make up over 50% of global GDP. These debt markets are not a fad; they are already large in market capitalization (rivaling/outpacing some US fixed income sectors) and will only become larger as the economies and capital markets grow. The private sector corporate debt in these countries is also already huge and growing; while this is newer it is certainly not going to be a passing trend.
    Investing shouldn’t be all or nothing. If you’re a diversified investor, put 5-10% of your portfolio in EMD products (I’d go with a mix of USD and foreign currency funds, find a EM corporate debt fund if you’re up for it), and it will be a sound decision for years to come.

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