The trigger for this sudden shift came from comments made in May by Ben Bernanke, then chair of the US Federal Reserve, which hinted that quantitative easing might be on the way out. The prospect of a stronger dollar helped draw money from riskier currencies back to the US, driving down yields in emerging markets and prompting investors to rethink their exposure to emerging market debt (EMD).

 

But not everyone has been frightened away from emerging market debt. According to Aberdeen Asset Management, some long-term investors actually used the sell-off to increase their exposure.

“We have seen very few outright institutional sellers of the EMD asset class and, in fact, most institutions that we were engaged with were looking at this as a perfect opportunity to allocate further rather than take away [from their EMD exposure],” says Steven Nicholls, London-based head of fixed-income product specialist at the asset manager. “We have seen a number of new mandates from companies and institutions that wouldn’t have been actively looking at EMD as recently as two years ago, but now see value in the asset class.”

 

Nicholls says most of the outflows in 2013 came from the retail sector. Nevertheless, the turbulence that rocked emerging bond markets in 2013 has highlighted the need for a change in the way in which investors are approaching the asset class.

 

There are three distinct flavours of EMD: government bonds issued in the local currency; government bonds issued in a more tradable currency (usually US-dollar denominated, but euro and sterling bonds are also available); and corporate bonds, which are typically issued in a hard currency such as the US dollar.

 

During the difficulties for EMD last year, it was local currency funds that suffered most (see graph). Nicholls says this prompted many investors to switch their exposure over to a hard currency investment, although this trend may now be starting to reverse.

 

EMD typically forms part of a life insurer’s return-seeking portfolio, which means they are more likely to go where the returns are greatest. The problem is that, while local currency returns might far outstrip the returns on offer from hard-currency EMD, having excessive currency risk on the books can be costly for an insurer. Solvency II, due to come into effect at the beginning of 2016, demands that 25% of capital be held against assets held in any currency other than the one used to prepare the insurer’s financial statements. At the same time, hedging the currency risk out – for example, by purchasing a deliverable forward contract – is often expensive.

 

One common way for companies to hedge forex risk is to purchase a forward contract that locks in the current exchange rate at a future date. This helps protect against sudden rate falls. However, since interest rates in many developing economies are so much higher than US rates, the cost of hedging into US dollars can be prohibitively expensive. On a standard forward contract, the forward rate – or price – that the purchaser has to pay is based on the spot rate at the time the deal is booked, with an adjustment made for the interest rate differential between the two currencies concerned. Forward traders can therefore create an expectation of what the exchange rate between the two currencies will be at the delivery date. For example, Steven  Nicholls, head of fixed-income product specialist at Aberdeen Asset Management highlights three components that typically produce a bond total return: the capital return, the income return (or carry) and the forex return. “Of the three components measured over the long-term, the biggest single determinant of return is carry,” says Nicholls. “In shorter periods, capital can have a big impact too, but significant movements in any one short period are often unwound in another.”

 

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