The emerging markets debt universe in broad. However, the common misconception is that emerging markets fixed income is a single asset class, Vontobel's Luc D'hooge writes.

Luc D’hooge, Head Emerging Markets Bonds at Vontobel Asset Management

The reality is that in purchasing power parity (PPP) terms, emerging market countries now generate over half of the world’s gross domestic product (GDP) making them the largest contributor to global economic growth. When the economies in your investable universe are making up an ever-greater share of the global economy, it’s an area you cannot afford to be out of.

Therefore, the challenge is not one of «to invest or not to invest» in emerging market bonds, but one of how to find the optimal allocation blend between the three asset classes within emerging market fixed income:

  • Hard-currency sovereigns
  • Local-currency sovereigns
  • Corporate bonds

By blending hard-currency, local-currency and corporate bonds in a portfolio, investors can achieve a diversified mix, while taking advantage of the inefficiencies present in emerging market fixed income that create both value mismatches and event-driven opportunities.

Strong Risk-Adjusted Returns

For bond investors, 2018 was not a year of plenty. However, emerging markets bonds have provided strong risk-adjusted returns over the long run and the fundamentals continue to be solid:

1. Economic growth in emerging markets still surpasses developed markets by far, despite an estimated decrease of 0.2 percent for emerging markets by the International Monetary Fund (IMF).

2. Emerging markets still represent only a fraction of asset capitalization, yet they contribute more than 50 percent of global growth, global trade, and global central bank reserves. This is should drive ever-larger allocations to emerging markets

Value in Frontier Markets

Recently, emerging markets have benefitted from good news from developed market central banks. So far, ETFs have seen strong inflows, which has helped the more liquid bonds, while some less liquid markets may have lagged. Therefore, investors can find the most value in frontier markets especially those in local currencies.

In addition, emerging market corporate bonds tend to profit less from ETF flows, so there must be value there. In sovereign bonds, non-benchmark bonds are most promising, in particular, the ones denominated in euro rather than dollars. However, some of these markets may not be accessible to all investors. Alternatively, investors can diversify via conviction funds – those funds that don’t care too much about benchmarks.

Allocate Actively

As emerging markets continue to take up a larger share of the global economy, it is inevitable that a rebalancing of allocations will occur. The prudent investor should approach their investment strategy, not as a question of in or out, but rather as one of where and how much to allocate between hard-currency sovereigns, local-currency sovereigns, and corporates.

After all, money left on the table does not deliver yield and carry; being in the market and optimizing your allocation does. This is why a blended approach to emerging market fixed income is the way forward to optimize returns for emerging market fixed income investors.