Research by the Sloan School of Management at Massachusetts Institute of Technology shows that an optimal allocation to Emerging Market Debt is between 8% and 35% of fixed income portfolio in rising rate environment

Emerging Market Debt (EMD) is a substantial and growing asset class that is increasingly of interest to institutional investors. Next to this, EMD prices have been pushed down this year by a strong US dollar and other technical factors. Does the sector now offer a good buying opportunity, especially in the face of rising interest rates and normalising monetary policies in developed markets?

New research conducted by a group of students at the Sloan School of Management at Massachusetts Institute of Technology (MIT) and supervised by NN Investment Partners (NN IP) shows that optimal allocation to EMD in a fixed income portfolio in a rising rate environment is between 8% and 35%, depending on investor risk appetites. Yet EMD’s weighting in major fixed income benchmarks is very small in comparison.

The research compared the risk/return profiles of a range of fixed income sectors in periods of rising rates over the last 15 years and produced optimal allocations to EMD in fixed income portfolios, given certain drawdown tolerance levels. Correlations between asset classes were used during  periods of rising rates. The research concludes that even those investors with the lowest drawdown risk tolerance of 0% drawdown over a one-year period would still benefit from an 8% allocation to EMD. For a moderate drawdown risk tolerance of -5%, the recommended allocation rises sharply to 26%. The optimal allocation for investors willing to accept drawdown risk of 15% is 35%.

Previous NN IP analysis reveals the high risk-adjusted returns available from EMD. First, the risk-return profile is comparably favourable. On 31 December 2017, EM local sovereign bonds had an almost identical yield to US high yield corporates but their aggregated credit rating was seven notches higher. Also, EMD corporate yield was almost 2% higher than US investment grade corporates despite a credit rating just two levels lower.

Second, NN IP believes EMD has structural advantages. For example, between 1983 to 2016, the average recovery rates on defaulted EMD sovereign bonds was roughly 54%, which was materially higher than those for corporate bonds. Also, no more than two EMD sovereign defaults have occurred in any one year, and while credit spreads tend to be correlated with US equities, there was no meaningful increase in EMD sovereign defaults during the global financial crisis of 2008.

Despite EMD’s size as an asset class, its favourable risk-return profile over the last 15 years and its solid fundamentals, allocations to EMD remain low. The NN IP Investor Sentiment EMD research of March 2018 indicates institutional investors typically allocate just 1-5% of their assets to EMD, while the sector’s share of key benchmarks is low: it accounts for just 2% of the Citi WGBI, 3.1% of the Bloomberg Global Treasury and 6.0% of the Bloomberg-Barclays Global Treasury indices. The prime reason for this is that EMD is not proportionally represented in global fixed income benchmarks because several bonds and countries do not meet inclusion criteria.

Marcelo Assalin, head of Emerging Market Debt at NN Investment Partners, said: “EMD is a fairly under-appreciated asset class. We encourage investors to look beyond the undue concerns and take a closer look at the data. The historical risk and return characteristics of EMD are very compelling, especially when the extra yield can act as a cushion against the headwinds created by rising rates.

“The market tends to overestimate the risks associated with EMD sovereign bonds which has created a more favourable risk and return trade-off than other fixed income asset classes for the patient investor.”

The NN IP Investor Sentiment EMD research has also shown that over half of institutional investors cite an insufficient understanding of EMD as a reason for low allocation to the sector, while three-quarters say it is because of a general perception of risk. Marcelo believes that a bias towards domestic investment markets is an inhibitor. In addition, he is optimistic that high-yield, hard currency EMD, EMD Short Duration and Frontier Market Debt have strong potential to outshine other fixed income asset classes in a rising rate environment. Local currency debt of shorter duration should also perform well.