Canadian institutional investors should have a strategic allocation to emerging market debt, Ward Brown, fixed income portfolio manager at MFS Investment Management, explained during his session.
EM debt has two of the key characteristics needed for a strategic allocation. First, it is a good diversifier because it has low correlations with other assets commonly found in Canadian institutional portfolios. Second, EM debt has had strong risk-adjusted returns, he noted.
Presenting a chart of EM debt returns relative to other fixed income assets over the last 10 years, Brown showed that, despite EM’s volatility, EM debt did quite well. Although local currency debt returns were not as strong as hard currency debt, Brown said he remains optimistic on the outlook for local currency debt because the valuations are very attractive. A key reason for the attractiveness of local debt valuations is that many central banks in EM started raising interest rates well before DM central banks, he suggested, and those rate hiking cycles may be close to an end, should inflation peak in the next quarter.
A good time to invest in local currency is when central banks stop hiking rates and re-establish higher yields because, as inflation starts to come down, there’s a cycle where currency appreciation is realized, he said. Brown noted that currency appreciation helps to deflate the economy, further enhancing the attractiveness of real yields.
In another example, Brown showed a chart of the spread of the main sovereign index over the last 15 years, noting that EM hard currency spreads were currently above the average for that period. Brown believes this elevation is temporary and is a result of the U.S. Federal Reserve hiking rates – which tends to be a bit of a headwind for EM assets – as well as the Russia-Ukraine crisis and the inflation spike seen globally.
He expects these sources of volatility to subside by the end of the year and spreads on the asset class to resume compression.
Most people don’t expect EM debt to lower the volatility of portfolio returns. However, Brown noted that the correlations are so low that the diversification benefits are quite strong for Canadian portfolios, particularly if using a blend of hard and local currency.
“That suggests that a strategic, permanent allocation to emerging market debt, included within dedicated exposure to both hard and local currency, could improve the efficiency of many Canadian portfolios.”