Stage is set for a star performance

Emerging market debt offers myriad chances to generate returns as economies in the region benefit from favourable demographics, strong domestic demand and robust fiscal status.

Many emerging market currencies are also undervalued on a purchasing power parity (PPP) basis, which compares exchange rates across various countries, and so have scope to appreciate. There are many Asian, African and Latin currencies that could be 30-50% undervalued relative to their PPP values.

Although emerging markets are in a robust and enviable position, and debt has provided its worth thus far in risk-adjusted performance terms, most investors have overlooked this asset class, dedicating less than 5% of their portfolios to it.

Even investors who do have exposure, many may do so via a traditional global bond portfolio, where the manager dabbles in emerging market debt as part of the broader asset allocation. Investors should gain their exposure via specialist emerging market debt managers to be in the best position. According to Mercer Consulting, over the past five years a median emerging market debt manager has beaten the benchmark by nearly 2% a year, versus global bond managers who have generally only delivered benchmark returns.

Investors may also consider different weightings than that traditional market cap indices. Most fixed-income indices, just like those for stocks, are heavily weighted to older industrialised countries with higher proportions of debt relative to GDP. Investors who follow market index weightings would consequently own a higher level of debt from heavily indebted, slow-growing economies.

There are risks associated with this asset class. Defaults would be the major risk in hard currency bonds, but local currency returns depend more on foreign exchange rates and shifts in local yields. However, as the market has broadened for emerging market local bonds, an investor’s main risk in a diversified debt portfolio is volatility – the market price fluctuations that capture all the foreign exchange interest-rate and political risks of the emerging markets sector.

However, over time, volatility has fallen to G-7 levels. It is also important to reconsider the risk in buying G-7 debt at historically low yields that are being driven by relaxed monetary policies. It is inevitable that interest rates in the G-7 countries will have to rise at some point, and that this will have a negative impact on returns.

Nor should the structural risks in advanced economies be underestimated. The Greek crisis has highlighted potential weakness in other European countries and prompted uncertainty about the euro. Of course, there will always be occasional emerging market setbacks, however a diversified emerging market debt portfolio should fare well considering the better asset/liability management at the sovereign level; improved fiscal policies, including better trade and current accounts, floating-rate currencies, which reduce the risk of imbalances, and record emerging market hard currency reserves that exceed emerging market hard currency liabilities.

A reconfiguring world provides myriad opportunities in the form of emerging market debt. Investors have too little exposure to this asset class and would benefit from rethinking their approach.