While a substantial majority of professional investors have some exposure in their portfolios to emerging market (EM) debt, their level of exposure to this asset class is surprising very low.
This is according to a research conducted by NN Investment Partners (NN IP), quizzing 108 professional investors, including institutions, family offices, banks, private banks, charities and endowments.
The respondents of the survey have an average exposure of 3.5% to EM debt. The most common reasons cited by investors for the low exposure are ‘greater investment priorities’ and ‘insufficient understanding of EM debt’.
Meanwhile, about 17% of respondents said they recognise the demand for EM debt is generally low. They cited risk as one of the key concerns.
About 77% of respondents recognise there is a general perception of risk around investing in EM debt, with 23% who think this is a serious risk.
What’s more, about 73% of the respondents said the investment risk versus the potential returns is an issue, while 52% said they are not given the risk or illiquidity budget within their remits to invest in EM debt.
Perceived risk vs real risk
Marcelo Assalin, head of emerging market debt at NN IP, told Citywire Asia that there tends to be a disconnect between investors’ perception of risk in emerging markets and the real risks, which explains why EM debt trades at wider spreads than debt in developed markets.
This general perception of higher risk is created by behavioural factors.
Citing an example, Assalin said investors could be home-bias and prefer to invest closer to home as they are familiar with these markets.
However, investors’ somewhat irrational biases should dissipate as investors become more familiar with the asset class.
Meanwhile, illiquidity could be a valid concern for investors, especially within the smaller countries and issuers in the emerging markets universe, and more specifically within Frontier Markets debt, Assalin said.
He said NN IP is monitoring liquidity risk in EM debt very closely. In fact, NN IP has developed internally a framework to evaluate this liquidity risk, which help the manager make well-grounded allocation calls.
The case for EM debt
The spectrum of EM debt instruments has expanded to a point that it is one of the most dynamic and diverse universes of debt markets globally.
The most mature sub-asset class – hard currency sovereign debt – was once an exotic investment but it has now become a mainstream asset class.
In 1998, only 10 EM countries with 10 bonds were trading.
Today, more than 65 are included in the hard currency sovereign benchmark – the JP Morgan EMBI Global Diversified Index.
EM debt flows
Citing data from JP Morgan and Emerging Portfolio Fund Research, Assalin said most asset classes – including the EM bonds, EM equities, US investment grade, US high yield and global equities – were seeing outflows in the last eight weeks.
Yet, the year-to-date flows to all of these asset classes remain firmly in positive territory, except for US high yield.
‘Within EM debt, we see that valuations have become attractive pretty much across the board including in sovereign spreads, corporate spreads, local rates and EM FX,’ he said.
Assalin said the current volatility in EM debt inflows and outflows is caused by retail flows.
Meanwhile, strategic long-term portfolios have always been seeing inflows since at least 2013, and continue to do so this year, he said.