Institutional investors turn to emerging market debt

This article originally appeared on benefitscanada.com.

North American institutional investors have been looking for yield in all the wrong places, 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 investors are increasing their exposure to global bond strategies, particularly, emerging market debt (EMD) and local currency debt.

“Traditionally, [their] focus 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.

Read: Emerging markets: Where are they now?

“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 emerging market debt, this shift hasn’t really taken place in Canada yet, says Ramanathan. Only 15% of Canadian investors will increase their allocations this year.

Read: Choosing emerging market corporates

Ramanathan says emerging markets offer a number of opportunities, including portfolio diversification and increased yield; the local currency debt rate in Brazil is 9.5%, and in Mexico, it’s 5.4%.

He also points out 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-scale investors],” he says. “When it was small, there just weren’t enough issuants.”

Read: Avoid dependent economies during downturns

Concerns

Investing in EMD doesn’t come without concerns.

“You do get nice yield in these [emerging market] countries,” says Ramanathan, “but you have to be able to manage the currency risk—that’s one of the trade-offs.”

Managing currency risk is a new thing for investors who are typically very passive in how they manage their currency hedging. But now, he says, they’re looking at currencies

There are other concerns too, however. 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.

Reade: Choose Mexico over China

“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, though, Ramanathan maintains 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 with lower yields in the developed world—as well as the need for diversification and meeting [expected] return rates—this is only going to be in an upward trajectory.”

Read: OSC issues guide for emerging markets