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Monday 22, January 2018 by Jessica Combes

Is there value in emerging market bonds?

 

Craig Mackenzie, Senior Investment Strategist at Aberdeen Standard Investment, explains that value is in emerging market bonds rather than US equities.

One of the big debating points now is: ‘Are equities getting expensive? In particular, US equities?’ The more expensive equities get, the more investors need to diversify their equity risk.
The problem is that investors traditionally would have chosen to diversify into US treasuries and bonds but the returns are really low. Put simply, getting out of equities into an asset class that offers lower returns is not very attractive. There is also a worry that the US Fed is going to raise interest rates, which will hurt bond returns.

It’s a bit of a dilemma for investors. The question is: ‘Are there other options?’ The good news is we do believe there are extensive alternatives to equities and traditional high-grade bonds. 

US equities vs. local bonds
We really like emerging market debt. The main reason is, if you take a basket of emerging market sovereigns like India, Indonesia, Mexico and Malaysia, the average yield on those bonds is about six per cent. The gap in yields between emerging markets and developing markets is bigger than it’s been for a long time.

Local currency bonds now offer high yields. Over the last five years there was a problem because the currencies of local bonds were quite expensive versus developed markets. Now most emerging market currencies are fair value compared to the dollar so there is no structural currency risk.

Inflation in many emerging markets is falling at the moment and as inflation falls, the central banks will take interest rates down and falling yields mean you get a bit of a capital return on top of that income yield. If you think equities are getting a bit expensive, as we do, you want to diversify, and emerging market debt is a very good proposition.

Three years ago we would have held five per cent of our portfolio in emerging markets bonds. We now hold now 25 per cent of our portfolio in emerging market bonds for this reason. 

Investor appetite
Most of our clients in the UK and Europe tend to like us to invest in the best-known indices and the standard best-known indices do not yet include Middle East bonds. However, there is a frontier index so we do now invest in that for Middle East. Again, the yields are considerably higher than developd market bonds at five or six per cent.

The Middle East represents about ten per cent of our emerging market exposure, which is not huge, but I’m sure over time as the region matures, it’s going to get included in the main emerging market indices and it will enter our portfolio on a wider basis.

We talked to a range of investors from small investors to big institutions in the GCC. The biggest institutions in this region are at least as sophisticated as Europe. In many cases, the senior investors went to the same universities and have the same financial qualifications. There are some very sophisticated investors here with some very sophisticated strategies and allocations to ranges of investments.

In today’s climate, traditional diversifiers like government bonds offer such low returns, and over the past five years we’ve worked really hard to find alternatives.

There are a whole range of more exotic asset classes like trade finance, litigation finance and catastrophe bonds. I was positively surprised to find that in this region, investors are well aware of these assets and they allocate to them. They understand the benefits and risks. Maybe 25 years ago, there might have been quite a big difference between investors in London and investors in the Middle East but that has disappeared now.

Alternatives
For a HNWI there are lots of niche opportunities that offer diverse investments. As equities get more expensive, they’ll want to shift out into, emerging market debt, and listed infrastructure funds. We think these are really attractive asset classes. There is liquid access with some meaningful diversification from equities.

We also like asset-backed securities. Many people have read about what caused the financial crisis and they know that securities got a bad name because sub-prime mortgage backed securities defaulted. While the bad reputation was deserved for this sector, it is undeserved for the class of assets as a whole, which saw low default rates during the crisis.

Asset-backed securities offer significantly higher returns than conventional bonds for the same credit rating. They also offer floating rates so that when the Fed raises interest rates the yields that they pay rise too, which is the opposite of conventional bonds where you end up losing money.

Emerging market debt, infrastructure and asset-backed securities would be a set of very good alternatives and diversifiers to the traditional bonds. What’s more, given how tight spreads are these days, traditional bonds have a much smaller role to play in portfolios than they did previously.

 The value of an investment is not guaranteed and can go down as well as up. An investor may get back less than they invested.

 

 

 

  


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