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EM local currency debt: the case for broadening the investment universe
The recent resurgence of interest in emerging markets (“EM”) local currency markets presents a conundrum for investors – the universe offers diversification, strong pockets of liquidity and compelling alpha opportunities.
So, why has it been so difficult to deliver positive performance on a consistent basis in the asset class? Should investors stay away for fear of getting burned again?
We argue that the traditional ‘beta’ measures for evaluating the asset class are misleading and, in fact, when viewing the opportunity set through a wider lens, the prospect of generating attractive returns with a lower volatility profile is much higher than conventional wisdom might suggest. Indeed, this would even have been the case in the last 10 years, despite it being a period of a strong USD and volatile returns amongst local currency portfolios.
In our piece, we take a deep dive into:
- The market through today’s lens: despite the breadth of the opportunity set, the most commonly used index – the JPM GBI-EM Global Diversified index – reflects only a very specific subset of the universe, limited to only the larger, more liquid markets.
- The case for broadening the universe: over the last decade, the EM local currency universe has seen significant growth, yet this development has not led to the broadening and further diversification of the local currency indices that international investors have tended to reference as a benchmark for their EM local investments.
- Development of additional segments of the EM local market: looking beyond the vanilla fixed rate, nominal sovereign bond universe, we highlight developments in the broader local currency universe that offer significant diversification potential; in a world where volatility is high, diversity is king.
- Accessing a range of instruments: another interesting asset base within the local currency space is the inflation-linked and floating rate bond universe, which offers excellent diversification tools in a high inflationary and rising interest rate world.
- Geographical diversification: the growth of the perceived ’frontier’ local markets offers further interesting diversification characteristics to the traditional EM liquid sovereign bond markets.
- Portfolio benefits of broadening exposure: looking across the four subcomponents of the entire EM local currency universe, we find an asset class filled with inherent diversification and natural cyclical opportunities, depending on the macro market environment.
Reaping the benefits of local markets
Although many would like to capitalise on the local EM investment opportunity, investors today are forced to choose between several imperfect beta category options when selecting the benchmark that they will reference.
Our observation is that the limitations of these beta categories can often hinder their ability to generate positive returns throughout the cycle. We argue that despite the absence of a benchmark that captures the broader opportunity set, portfolio managers would benefit from seeking investment opportunities across the universe, extending beyond the constraints of their chosen benchmark.
To this end, extending exposure to the full set of countries, the higher-grade corporate sector, or other inflation-linked or floating rate instruments will allow managers to build portfolios that avoid the pitfalls associated with overly concentrated exposures.
Indeed, portfolio construction that allows for a higher tracking error in a benchmarked portfolio, or effectively taking a total return approach to asset selection, should allow investors to take advantage of precisely the benefits that draw them to the local currency asset class without compromising their other portfolio objectives. Instead, strong understanding of the macro dynamics, combined with robust bottom-up credit analysis, can allow for an improved return profile with lower volatility throughout the cycle.
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