Many emerging market economies have strengthened, putting them on firmer footing for future growth. We believe valuations remain attractive but this asset class needs careful handling: investors should look for a quality-focused approach with risk mitigation central to the process.
Given improving fundamentals, now could be a good time to increase allocations to EM. And with certain currencies undervalued, the case of- EM debt strategies denominated in local currencies appears even stronger.
Why emerging market bonds?
Over the last year and a half, many emerging market economies have become structurally stronger; countries such as Brazil and Russia have made significant progress.
The International Monetary Fund recently raised GDP growth forecasts for the emerging world. Growth-friendly monetary policy is a key supporting factor: lower interest rates lift consumer spending which in turn boosts domestically-driven economic growth.
President Trump's trade-related policy rhetoric created concern among investors as emerging markets often rely heavily on exports. However, many of Trump's policies have been either watered down or dropped.
We believe that the above strengths are not priced into most emerging market securities. Furthermore, we see significant upside in some local currencies before fair value is reached.
How to get fundamental about EM investing?
While traditional EM market-cap bond funds aim to diversify risk by offering broad market exposure, in reality, market-cap investors can often be overly exposed to the most indebted countries. It is therefore important for investors to consider the fundamentals of emerging nations when choosing their EM allocation.
A focus on quality
Building a portfolio according to strength - rather than size - can help to focus the portfolio on quality bond issuers while reducing the reliance on trading. This latter point is especially important given that it is now much harder to buy and sell bonds - market liquidity is impaired in the new investment paradigm.
Strong risk controls
Investors should beware that a number of risk factors still exist for the asset class. These might include an unexpectedly aggressive increase in US interest rates or a sudden return of trade protectionism to the political agenda. In addition there are political risks within emerging markets themselves.
As emerging markets are a collection of very diverse economies, it follows that the impact of various risk scenarios will vary significantly from country to country. Our approach puts risk mitigation at the centre when assessing each emerging market.
The fundamental approach to fixed income:
- Greater diversification including access to China and India
- Less concentrated risk when compared to traditional market cap indices
- Lending is based on a borrower's ability to repay rather than their capacity to borrow
For illustrative purposes only. Allocations are subject to change
Why access the fundamental approach via an ETF?
The number of investors using fixed income exchange traded funds (ETFs) continues to rise. As challenges in the bond markets continue to prevail and with traditional bond dealer inventories reduced, investors have increasingly been turning to the ETF vehicle as a way to potentially mitigate liquidity risks. This is because the ETF structure is able to provide fixed income investors with an additional layer of liquidity via the secondary market. Compared to traditional unlisted funds, this secondary market can provide investors with intraday liquidity and real time price In an environment where there may be liquidity concerns in the underlying bonds, this secondary market structure can help address these concerns as it introduces the bond inventories held by those market participants, who support ETF trading.
For more information, visit www.etfsloim.com/emergingmarkets
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