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North American institutional investors have been looking for yield in all the wrong places it seems. But that’s starting to change.

Pyramis Global Advisors, a Fidelity Investments Company, recently released a survey of more than 600 institutional investors in 16 countries. The results indicated that investors are increasing their exposure to global bond strategies, particularly, emerging market debt (EMD) and local currency debt.

“Traditionally, the focus by big pension plans has been on Canadian fixed income or U.S. fixed income,” says Karthik Ramanathan, senior vice-president and director of bonds with Fidelity Investments. Now, however, plans are starting to look outside their home borders.

“When you think of this in terms of Japan, the U.S., Germany, the U.K., with [interest] rates really hovering about 1.7%—and target returns for many pension plans significantly higher, in the 5% to 8% range—you’ve got to search for yield and more tactical opportunities.”

While Europe and Asia have much more experience investing in EMD (according to the Pyramis survey, 47% and 37%—respectively—of investors in these continents, are looking to increase allocations to EMD), this shift hasn’t really taken place in Canada yet, says Ramanathan. Only 15% of Canadian investors will increase their allocations to EMD.

Ramanathan says that EMD offers a number of opportunities, including portfolio diversification and increased yield (e.g., the local currency debt rate in Brazil is 9.5%; in Mexico, it’s 5.4%).

He also points to the fact that the EMD space has become a $12-trillion market, roughly a 10-time increase over the last decade. “It’s finally a market that is investable for large Canadian pension plans,” he said. “When it was small, there just weren’t enough issuants.”

Concerns
However, investing in EMD doesn’t come without concerns. “You do get very nice yield in these [emerging market] countries,” says Ramanathan, “but you do have to be able to manage the currency risk—that’s one of the trade-offs.”

Managing currency risk is a new thing for many pension plans, says Ramanathan, as typically, they are very passive in how they manage their currency hedging (e.g., not hedging at all or taking a static approach). But now, he says, pension plans are looking at currencies as a source of alpha, a source of adding value.

“From this perspective, these pension plans need expertise on the currency side, risk management on the currency side.”

There are other concerns, too. Spreads could continue to narrow, says Ramanathan. If this happens, investors need to take into account the potential risks just as they would with any sovereign debt market or corporate debt market.

“You don’t want just to be chasing yields; you want to be chasing value-added propositions in companies and sovereigns.”

As well, emerging market countries could be impacted if global growth slows. Ramanathan says that could affect how these bonds may perform and what central banks might do in these countries. “[Banks] may actually start lowering rates, and that could put inflationary pressures in place.”

Concerns aside, Ramanathan says EMD is an asset class on the rise. “Given that Canadian interest in EMD has grown to a small amount over the last few years, the expectation is that with lower yields in the developed world and the need for diversification and meeting plan return rates, this is only going to be in an upward trajectory.”

© Copyright 2014 Rogers Publishing Ltd. Originally published on benefitscanada.com

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