A Spectrum of Possibilities: The Emerging-Market Debt Tool Kit
Emerging-market debt (EMD) can be a valuable addition to a portfolio. The key is to recognize that EMD is not one homogeneous sector: it spans several sectors, each with its own set of risks and return opportunities. To select the best strategy to fit their objectives, investors need to ask a series of questions.
Investors look to EMD to meet different objectives—including yield, diversification and exposure to strong macroeconomic trends. For many people, the choice of strategy initially falls into three main categories:
- Hard-currency sovereign debt, for example the J.P. Morgan Emerging Market Bond Index Global (EMBIG)
- Hard-currency corporate debt, for example the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified
- Local currency sovereign debt, for example the J.P. Morgan Government Bond Index Emerging Market Global Diversified
But investors need to dig deeper to understand what each of these sectors can bring to their portfolios. The best way to start the conversation is by recognizing that, in fact, EMD spans several different types of risk and return. All fixed-income instruments have three broad sources of risk and return: interest-rate, credit and currency exposure. The table below shows the sources of those exposures for the three main EMD sectors.
This breakdown helps start the conversation about which tools an investor should be using:
- US or emerging-market(EM) interest-rate exposure? (For the sake of simplicity, we’ll assume investors are US-dollar based.)
- US (hard-currency) or emerging (local) currency exposure?
- Sovereign or corporate credit exposure?
- Investment-grade or high-yield credit?
Clients frequently ask me for my view on what is currently the “best” opportunity in emerging-market debt and they are often curious when I say: “It depends”—because there is no single “right” approach to investing in EMD. The main thing is to match your strategy to your objectives. Investors can choose how much risk they’re willing to accept, and where they want that risk to come from.
For example, a yield-seeking, volatility-tolerant investor who wants to benefit from EM growth dynamics and falling structural inflation rates might choose exposure to EM currencies and the local-currency sovereign bond market. This would mean earning returns from a combination of the potential appreciation in EM foreign exchange rates, the yield on local currency instruments and the price changes in EM government bond yield curves. Historically, this strategy would have been one of the highest-return, highest-volatility choices available in EMD.
By contrast, a US investor whose main concern is to diversify issuer-specific risk in a portfolio of developed-market credit might choose exposure to the EM hard-currency corporate market. As the currency and interest-rate exposures are US based, credit exposure is the only component where the risks and returns are directly derived from emerging markets. A key attraction of this strategy is that it would significantly increase the investor’s opportunity set, opening up a choice of many more corporate bond issuers.
Of the EMD strategies above, no single strategy on its own allows investors to exploit all the available sources of return and risk. We recommend thinking about the asset-allocation decision in two parts.
The first step (the beta decision) is to identify the sources of risk and return that best fit the investor’s objectives. This is the primary source of market exposure, and investors who use a benchmark, might consider one of the indices above.
The second step (the alpha decision) is deciding which additional opportunities the investor wants to pursue. This would mean giving the portfolio manager some latitude to invest selectively in other sectors. For example, an investor with a portfolio of high-grade EM sovereigns might choose to add some corporate exposure and take some selective currency exposure—comparable to a “core-plus” mandate for a developed-market portfolio.
In the coming weeks we’ll take a deeper look into how the EMD tool kit can help investors meet a range of objectives.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio managers.
Paul DeNoon is Director of Emerging Market Debt at AllianceBernstein.