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Local currency emerging market debt offers attractive risk adjusted returns, according to international investment firm PDF Print E-mail
News - Latest
Monday, 11 April 2011 06:48

Interest from investors in emerging market debt is set to continue as not many asset classes can offer comparable sources of outperformance from income, capital gains and FX appreciation, it is claimed.

According to international investment firm Baring Asset Management with EM countries now at differing stages of their economic cycle, and inflation causing some concern for a number of central banks, there is a need to take a scenario based top down approach.

‘In our view, local currency emerging market debt offers some of the most attractive risk adjusted returns. Indeed, the demand for emerging market debt continues to increase as OECD-based pension funds and domestic EM pension funds build on their currently limited exposure,’ said Thanasis Petronikolos, manager of the Baring Emerging Markets Debt Local Currency Fund.

‘However, we have witnessed recent volatility in the EMD market caused by geopolitical tensions in the Middle East and Africa and some profit taking after a strong rally in December,’ he added.

But in spite of some volatility, higher productivity growth rates and better demographics are reflected in the strong growth potential for emerging markets, especially when compared with developed markets, he believes.

Barings highlights that as long as investors continue to search for yields in the current ultra low interest rate environment, the case for emerging market debt will remain strong, as coupon yields are attractive at around 6%.

‘The convergence story for emerging market currencies is still valid. They are, on average, undervalued, and though risk premia are falling, they are still high. This asset class also allows us to actively manage the capital gains potential of these markets to enhance total returns. Active management of the interest rate risk, active management of corporate and government credit risk, and the continuing reduction of risk premia still incorporated in EM bonds all offer great opportunities for us to outperform,’ explained Petronikolos.

Currently, the Baring Emerging Markets Debt Local Currency Fund retains an overweight allocation to emerging Europe, made up of exposure to Hungary and Poland. In Latin America, the manager favours the Mexican bond market in terms of both bonds and currency after the bank of Mexico retained its benchmark interest rate of 4.5%, extending its longest ever interest rate pause.

‘Within emerging market debt we believe the greatest opportunities lie within local currency because of the opportunities for income and capital gains as well as FX appreciation. Local debt currently accounts for 80% of the total $6 trillion EM debt universe and within this it is expected that the share of emerging local sovereign and corporate debt will rise,’ said Petronikolos.

‘Although EMD remains subject to global economic volatility, the resilience of this asset class has been proven after several financial crises including that of 2008. The inclusion of EM local debt can improve the return/risk profile of both global bond and balanced portfolios as modest correlations with developed asset classes provide diversification benefits,’ he added.

Baring Asset Management takes a top down scenario approach to its emerging market debt investing. Following a rigorous macroeconomic analysis of fundamentals, high conviction ideas are generated and strategic core positions with a medium to long term investment horizon are taken. Tactical positions are used to exploit short term opportunities. The fund has returned 12.1% over 12 months to 28th February 2011.

 

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