European institutional investors and bond managers are moving up the risk spectrum, favouring emerging market debt and high yield bonds in current fixed income allocations in the increasingly difficult search for yield.
Their willingness to embrace more risk in their fixed income portfolios in order to obtain yields of over 5% is likely to be emulated by asset owners in Asia and beyond as they struggle to reach annual fixed income investment return targets amid historically low interest rate levels.
A group of 42 chief investment officers, fixed income heads, consultants and asset managers – mainly based in Europe – were polled at the Institutional Fixed Income Virtual Summit 2020 hosted by Clear Path Analysis on October 20 and 21. Twenty-two percent nominated emerging market debt as a favoured asset class to expand, while 33% named high yield corporate debt, the same amount that favoured investment grade corporate bonds. Only 6% said they intend to grow developed market government bond exposures in their portfolios.
“Risk appetite is larger than I thought it would be for high yield at a time where we're seeing a second wave of Covid-19 [in Europe] and perhaps [Europe] having a double dip recession," said Hitendra Varsani, quantitative investment strategist at MSCI in London, also speaking at the summit.
It also appears well-timed, given a likely busy pipeline of new deal flow leading into 2021.
On November 2, a report by Goldman Sachs predicted emerging market sovereigns would issue $140 billion of bonds in 2021 to cover funding shortfalls caused by the pandemic, following $145 billion of issuance so far this year. Report authors Teresa Alves and Sara Grut predict emerging market high-yield sovereign issuance will rise to $60 billion in 2021 from $45 billion in 2020, versus a slowdown in investment-grade issuance to $80 billion from $100 billion. They expect Gulf and Latin America to lead this new deal flow, followed by Asia.
Emerging market debt remains attractive despite falling yields, agreed Kris Lasocki, investment manager at the UK's Royal Mail Pension Plan, who also spoke at the summit. “[Emerging market debt yields are] a bit depressed but still the premiums and the spreads over developed markets of 400 to 450 basis points are attractive, undoubtedly.”
He noted that hedging local currency emerging market debt can be costly but that the instruments remained an attractive prospect, with some investors increasingly willing to get a naked exposure to the debt.
Some asset owners have also enjoyed less expensive hedging costs, too. In Asia for example, Korea and Japanese investors have seen the cost of hedging US dollar debt dropping markedly since last year, which has made dollar bonds more compelling investments.
“If you are comfortable with a bit of currency risk, then local is a great place to be,” Lasocki said. “Some corporates in emerging market debt are less risky than the US high yield space. The times when emerging markets were risky just because they were emerging are long gone.”
On the other hand, the US dollar bonds of emerging market borrowers with appreciating local currencies have attracted some European investors. Rupert Stow, chief investment officer at Utmost Worldwide, a provider of life insurance-based wealth managment solutions, told AsianInvestor that he was considering allocating to emerging market debt for the first time, including in Asia. He said issuers of hard currency bonds – both sovereign and corporate – would find the debt cheaper to service due to stronger local currencies.
“It is the beginning of our journey, but affordability will increase with the decline in the dollar, which might be a [good] long-term theme,” he told AsianInvestor, predicting further weakening of the dollar against emerging market currencies.
China’s currency has gained 5.9% against the dollar since the start of April; Taiwan’s is up 5% over the same time.
Stow added that while spreads had narrowed since the spring, there remained plenty of performance to be enjoyed given the prospects for higher growth in many emerging market economies.
Investors have also become notably more willing to buy emerging market bonds, with asset managers predicting strong returns. In September for example, AsianInvestor reported the growing interest of Resolution Group in higher yielding bonds, including Asian credit markets, on an opportunistic basis.
In a recent research note, Pierre-Yves Bareau, head of emerging market debt for JP Morgan Asset Management, predicted the emerging market debt offered returns of between 11% and 12%. The company favour hard currency sovereign debt.
“Hard currency emerging market debt has rarely been rated so strongly at the current valuations,” Bareau noted. HSBC Global AM, meanwhile, predicts the entire emerging market debt universe will yield an average of 6% per annum over the next 10 years.
Demand from yield-hungry investors have also enabled high yield companies to issued debt this year at a record pace.
In the year to August, the value of high yield bonds issued by US nonfinancial corporates increased 119% on the same period a year earlier, to a record high of $387 billion; those in Europe increased by 38% to $152 billion, according to Moody’s data [published September 25]. Hard currency emerging market debt issuers in Asia raised $80 billion between May and June alone, according to JP Morgan Asset Management.
Joe Marsh contributed to this article.
AsianInvestor and Credit Suisse Asset Management will be hosting a webinar on November 24 entitled 'Emerging Markets Corporate Debt – Navigating the Unknown'. For more details and to register free of charge, please click here.