In focus - Markets

The case for a core allocation to emerging market debt

A commonly held, but misplaced, belief that emerging market debt is an obscure and risky outpost of the fixed income universe has resulted in its under-representation in many portfolios.

19/06/2019

Duncan Lamont, CFA

Duncan Lamont, CFA

Head of Research and Analytics

Peter Ozelius, CFA

Peter Ozelius, CFA

Assistant Portfolio Manager, Emerging Market Debt Relative

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CPD Accredited

Whether it is hard currency (US dollar) or local currency denominated, emerging market debt (EMD) has qualities that are similar to, or even better than, other core fixed income allocations. Our analysis demonstrates that a strategic allocation to EMD should improve risk-adjusted return potential for portfolios of all degrees of sophistication.

Emerging market economies have grown in prominence and now represent around 40% of global GDP, twice their level at the turn of the millennium. In addition, emerging market debt now represents 18% of the global bond market. Despite that, many investors hold far less than that, and portfolios with no money allocated to EMD at all remain widespread.

One reason is that the common perception of EMD is that it consists of a basket of hard-to-analyse credit risks, appropriate for holding only as a tactical allocation. However, an analysis of the full opportunity set reveals something very different. It comprises a mix of bonds correlated to various macroeconomic risks, traditional fixed income drivers, and yes, idiosyncratic credit risk that has a varied set of market drivers.

These building blocks, within a broad and diverse emerging markets portfolio, will share the characteristics – but not materially increase the risk – of the rest of a typical investor’s fixed income portfolio. That is, they incorporate a mix of interest rate risk, credit risk and currency risk where parts of the portfolio respond to various drivers differently than other parts.

Our analysis suggests that many portfolios would benefit from the inclusion of EMD. Investors who fail to allocate to this area are missing out on an opportunity to improve absolute and risk-adjusted returns.

Our full research paper exploring this issue in detail is available as a PDF below.