Industry Voice: The Potential Benefits for European Investors of a Strategic Allocation to Emerging Market Debt

clock • 8 min read
Industry Voice: The Potential Benefits for European Investors of a Strategic Allocation to Emerging Market Debt

After a tumultuous year for capital markets in 2022, investors will likely face more uncertainty in 2023. However, there are several bright spots — inflation is beginning to moderate, central banks are slowing the pace of tightening and fixed income valuations are now attractive across many sectors.

Against this backdrop, emerging market debt (EMD) may warrant a closer look for European investors as it offers attractive yields relative to other fixed income asset classes with lower volatility than equity assets.

While emerging market investing is familiar to European investors, it is often underrepresented across portfolios. Much like emerging market equities, EMD allows investors to gain access to higher-growth and higher-productivity economies compared to developed market economies. Additionally, EMD has matured significantly as an asset class over the past 30 years. In the early 1990s, there were few countries in the index, and crises from the mid-1990s to the early 2000s resulted in the asset class being perceived as a high-risk proposition. Today, many EMD issuers have robust debt profiles and better credit quality than in the past. Furthermore, the depth and breadth of liquidity has increased as the size of the overall market has grown to approximately €4.7 trillion,1 and EMD now comprises nearly 16% of the global bond universe.

Emerging market debt can be divided into two main sub-asset classes: hard currency and local currency. Hard currency EMD refers to debt issued primarily in USD but also in euro and yen. Local currency EMD refers to debt issued in the issuer's domestic currency. Hard currency EMD can be hedged back into euros or left unhedged. For local currency EMD, hedging the currencies is often impractical because it can be a complex and costly process.

What are the key portfolio characteristics of EMD?

In considering an allocation to EMD, it is important to understand the volatility and correlation characteristics of the asset class. It is often assumed that local currency EMD is more volatile than hard currency EMD. However, the volatility profile depends on the home currency of the investor. As shown in Exhibit 2, local currency EMD has exhibited higher volatility over the past 10 years for US investors,

averaging 11.4% as compared to hard currency EMD volatility of 9.0% over the same period. In euro terms, however, the volatility of local currency EMD has been much lower at 9.2%, comparable to unhedged

hard currency EMD, which also averaged 9.2%. Hedging the US dollar exposure from hard currency EMD reduced the overall volatility slightly to 9.0%.

Exhibit 3 shows the correlations between the different EMD assets, and we see a potential diversification benefit between hard and local currency with a correlation of roughly 0.7, varying slightly depending on whether the hard currency is hedged to euros or not.

Assessing EMD in a euro investor's portfolio

To analyze the potential benefits of adding EMD in a euro denominated portfolio, we estimated the potential returns that a euro-based investor might experience over the next 10-years. We started with current yields and then made adjustments for hedging costs, default rates and currency depreciation based on current market conditions. We then estimated volatility based on historical data and calculated expected Sharpe ratios, as shown in Exhibit 4.

 

 

 

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