Some Middle Eastern institutions tend to be cautious about allocating outside their home region, but emerging market debt is becoming too big an asset class for them to ignore, says Steve Cook, managing director of EM fixed income at PineBridge Investments.

That's particularly the case as falling yields in local bond markets in Middle Eastern countries are leading domestic investors to look elsewhere for higher-yielding assets, he notes.

This is despite concerns in some quarters that flows into EM debt – particularly corporate bonds – in recent years have been so large that the market is in danger of overheating.

But the EM hard-currency corporate bond market (combined investment-grade and high-yield) globally stands at around $1.5 trillion, against some $5 trillion of US investment-grade debt, notes London-based Cook. That is despite the fact that US GDP accounts for around 25% of global GDP, while EM GDP accounts for around half, he points out.

Moreover, he adds, the increase in issuance of EM corporate bonds in the past three to four years has mostly been for refinancing purposes. “We’re not seeing a big uptick in defaults or leverage ratios. Probably in the next five, seven, 10 years you’ll see more M&A activity, but the bulk of new issuance has been for refinancing.”

According to rating agency Standard & Poor’s, defaults in 2013 for EM high-yield corporate bonds stood at 2.2%. Cook says this is in line with US high-yield and leverage ratios, of just over 2.5x, up from around 2.2x in 2011, as estimated by Bank of America Merrill Lynch.

Last year saw the biggest outflows from EM debt since the 2008 crisis ($42 billion), but “to put the numbers into context”, that is not a huge amount relative to the roughly $5.2 trillion in EMD, says Cook. Still, withdrawals continued in the first quarter of 2014, when a further $17.2 billion was pulled out, although in the past week or so that trend has stopped.

Ultimately institutional investors are seeking higher-yielding alternatives, as US investment-grade spreads continue to compress, says Cook. “Previously investors were able to diversify into European sovereign bonds, but the eurozone debt crisis meant they have retrenched and looked for alternative asset classes.”

The EM corporate debt market is a lot more diverse than a decade or so back, he adds. In 2000, assets were split around 90% between Latin America and Asia (with about 45% each). Now the breakdown is roughly 35% emerging Asia, 32% Latin America, 21% emerging Europe and 12% the Middle East and Africa.

There has been significant demand for investment-grade EM corporate bonds from investors that previously only focused their credit allocations on US IG and high-yield, but have seen the yield and diversification benefits of such an allocation, adds Cook.

That said, it’s still relatively rare for certain institutions – particularly pensions – to seek corporate-only EM debt mandates or for consultants to recommend such portfolios to pension clients, he notes. They still tend to focus on blended corporate/sovereign strategies, says Cook. “But I think that will change over time.”

“Consultants don’t change their recommendations on strategic allocations to a new asset class overnight,” he adds. “And the EM corporate debt market has changed so rapidly in a short period of time that they need to do more research first before making recommendations.”