Emerging-market fixed income is growing in appeal as an asset class, but investors are wary of higher volatility in EM corporate credit and local-currency bonds, says Pictet Asset Management.

Nevertheless, on the whole, investors are readier to take longer-term allocations to EM fixed-income securities than they were in the past.

Simon Lue-Fong, head of emerging-market debt at Pictet Asset Management, points to a higher level of comfort now with longer-term EM debt maturities of 10-plus years.

“Assets were much more flighty in those days, and maybe for good reason,” he says. “But then people saw how quickly EM debt prices came back. In 2008, the emerging local-currency debt asset class only suffered a loss of 5% for the year, and bounced back strongly with a return of almost 22% in 2009.

“The capacity for [EM] countries to pay back money they’ve been lent is clearly there,” adds London-based Lue-Fong. “The compounded coupon effect is also quite strong – and people are realising the coupon from EM debt will be high for a while. So they are prepared to buy and hold.”

Specifically, Pictet AM is cautious on the short-term outlook for emerging-market corporate credit. For the firm’s EM debt strategies, this is an off-benchmark asset, and the maximum the firm can invest off-benchmark is 30% of the total EM fixed-income portfolio.

Its overall exposure to EM corporate credit (in US dollar or local currencies) has historically been between 0% and 15%, and is now close to zero.

“EM credit has had a great run recently, particularly in the first six weeks of the year,” notes Lue-Fong. “But the situation may be turning due to issues such as the eurozone crisis, potentially slowing US growth and China looking a bit weaker in terms of data. There are a lot of red flags out there right now that may make us be a bit more cautious in the corporate credit space.”

Instead, Pictet AM wants be long government bonds, short currency and flat credit. “Being long government bonds enables us to benefit from rate cuts that are not yet priced into the curve, particularly as EM central banks look set to cut rates further if growth surprises on the downside, says Lue-Fong. “To express our defensive view, we underweight emerging currencies as well as having virtually no exposure to corporate credit.”

Breaking EM debt down into hard versus local currency, US dollar EM debt posted much better returns (7%) than local-currency last year (-1.8%), by the JP Morgan EMBI Global Diversified and JP Morgan GBI-EM Global Diversified indices, respectively.

This big dispersion between hard- and local-currency EM bond returns probably caught a lot of people by surprise, suggests Lue-Fong.

They are far closer together this year, with the local-currency benchmark up by 1.37% and dollar debt up by 3.44% as of June 1.

Interestingly, there’s been greater interest in hard currency globally this year, he notes. “Some of that reflects a lag in response after what happened last year. It probably also reflects the fact that people are more cautious about the outlook now.”

That’s because local-currency debt is bound to be more volatile in terms of returns, due to the 20-30% of local-currency returns that come from currency movement. Hence in less certain times, investors are more likely to buy dollar-denominated assets.