A delicate balancing act

16 Mar 2021

Emerging market debt has become an increasing area of interest to international investors, yet, the economic impact of the pandemic means that such exposure has become more of a delicate balancing act between risks and opportunities.

With spring and the roll-out of the Covid vaccinations progressing, investors are gearing up for a gradual emergence from their year-long forced hibernation. But lasting scars of the crisis will continue to shape the world economy, most importantly a combination of persistent financing needs and a rising debt burden.

Throughout the past year, global borrowing surged to 350% of GDP, adding a record $24trn (£17trn) to global debt levels, which now stand at $281trn (£200trn). Across emerging markets, debt-to-GDP increased to 250% of GDP in 2020, up from 220% a year earlier, according to the Institute of International Finance (IIF).

The initial investment appeal of emerging markets is twofold. Compared to developed markets, many emerging economies have not been hit as hard by the Covid pandemic and facing a relatively stronger growth outlook. The IMF predicts that emerging markets are set to grow by 6% this year, compared to 3.6% across developed markets.

Added to this is the fact that following an initial sell-off in March 2020, investors found that the emerging world offered relatively better value compared to its developed market counterparts, where three quarters of bonds are trading at negative yields.

The cash could not have come at a better time for many emerging markets, many of whom have faced a sharp widening of fiscal deficits and mounting expenses due to the pandemic, turn- ing access to market financing into a key factor for their successful recovery from the pandemic. Over the next two years, some $10trn (£7.1trn) worth of emerging market bonds are scheduled to be refinanced.

It is no wonder then, that emerging market governments are keen to lock in favourable rates. In the opening month of 2021 alone, emerging market governments borrowed more than $100bn (£71bn). The surge in borrowing was heavily dominated by government debt, most of which was issued in local currency. Whenever emerging market sovereigns enter capital markets, they were met with a flurry of investor demand. Saudi Arabia’s $5bn (£3.5bn) bond in January, for example, was heavily oversubscribed, attracting more than $20bn (£14.2bn) of interest. A decade after the Arab spring, Egypt returned to the bond markets with a $3.8bn (£2.7bn) issuance, which met with more than $16bn (£11.4bn) of bids.

The surge in investor interest also includes plenty of examples from UK institutional investors, as the combination of fixed income and relatively higher returns neatly matches the income requirements of defined benefit schemes.

LGPS Central, for example, launched a £630m Global Active Emerging Market Bond fund in January which was backed by the local authority pension schemes in Cheshire, Leicestershire, Nottinghamshire and the West Midlands.

Other schemes have sought targeted exposure to the asset class for many years. This includes Centrica, which has about 8% of its portfolio invested in an actively managed emerging market mandate, predominantly invested in soft currency debt, whilst giving room for optional allocations to hard currency corporate debt as Chetan Ghosh, chief investment officer at Centrica, explains.

The Pension Protection Fund (PPF) has used the opportunity provided by March 2020’s market rout to increase exposure to emerging market debt, as Ian Scott, head of investment strategy, explains. “We have had a positive view regarding for the prospects of emerging market debt. Hard currency debt in particular suffered terribly in the March sell-off, much more than was justified by fundamentals. It wasn’t a market that was supported by the Fed in the way that high grade US debt has been and because it was relatively liquid compared to local currency debt, it went to levels that really had no justification, it even underperformed local currency debt in March.

“So, at that point we did venture back into the hard currency area and allocated capital there, which proofed to be correct. And over time, as the risk appetite in the market improved, the discount we enjoyed in hard currency unwound and we started to move more into local currency debt.”

Similarly, the Royal Mail Pension Plan also holds a significant allocation to the asset class. Investment manager Krzysztof Lasocki also expresses cautious optimism. Speaking at a portfolio institutional event last year, he stressed the importance of an actively managed approach to accessing emerging market debt, and that portfolio managers should have the opportunity to switch between hard and soft currency as well as sovereign and corporate debt.

Investment case

Investors approaching the asset class with caution have every reason to be wary. Emerging market debt is characterised by high levels of volatility. In the past, surges in inflows have been met with even sharper outflows, with painful consequences, not just for investment portfolios, but also for the public finances of the countries involved.

The most recent example is the 2013 taper tantrum, when the prospect of the US Federal Reserve’s taper tantrum triggered a scramble to sell emerging market debt. Compared to eight years ago, debt levels are now a lot higher. Back in 2013, the global debt-to-GDP ratios was at just over $200trn (£143trn), it is now at $281trn (£200trn) and rising rapidly. Meanwhile, while the Federal Reserve balance sheet expansion doubled to $2trn (£1.4trn) in the four years preceding the 2013 tantrum. During the past year, it has surged far above the $6trn (£4trn) mark. A lot more money in circulation means that the effects of another round of tapering could also be much more painful.

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