Actively Emerging: Opportunities in Debt

Transcription

1 Aon Hewitt Retirement and Investment Actively Emerging: Opportunities in Debt Risk. Reinsurance. Human Resources.

2 Executive summary Emerging Market Debt (EMD) offers higher yields relative to developed market debt. This is to compensate investors for domestic risks including political upheavals, volatile growth and currency fluctuations. More recently, EMD performance has been driven by factors including economic slowdown in China, falling commodity prices and uncertainty surrounding US interest rate rises. For clients who wish to allocate to EMD, our primary recommendation is to engage an active EMD manager, if the governance framework allows. We highlight the high dispersion in returns between individual EMD countries in addition to the difference between Hard and Local EMD market returns. We see this as a potentially attractive source of return for active managers. The active investment approach includes rigorous top down and bottom up analysis to identify individual EM countries with compelling risk/reward profiles. Active managers are typically not restricted to benchmark exposures and can thus increase diversification through off-benchmark exposures and improve returns through accessing a widened opportunity set. They also have the flexibility to significantly reduce risk by being underweight high beta exposures which could potentially add value in a risk-off environment. Aon Hewitt Actively Emerging: Opportunities in Debt 2

3 Emerging Market Debt overview EMD is issued by governments, municipalities or corporations within developing economies. EMD can be further classified into Hard (issued in a developed market currency, typically USD) or Local (issued in the domestic currency). A range of index providers, including JPMorgan, construct indices that track the performance of EMD. The table below provides a summary of three key JPMorgan EMD indices and a developed market index for comparison. Overview EMBI Global Diversified (Hard EMD) GBI-EM Global Diversified (Local EMD) CEMBI Broad Diversified (Hard EMD) Barclays Global Aggregate (USD hedged) Issuer type Sovereigns and Government agencies Sovereigns Corporates Sovereigns, Government agencies, Corporates, Securitised Interest rate/ currency exposure US/US dollar Country/local currency of issue US/US dollar Global/US dollar Sources of return (in USD terms) US Treasury yield + spread Local Government yield +/- currency movements US Treasury yield + spread Government yield + spread Market cap ($bn) ,952 Yield 6.39% 7.13% 6.42% 1.77% Average credit rating* Baa3 Baa2 Baa2 Aa % of issuers rated investment grade 56% 70% 63% 100% No. of Countries Duration (years) *Based on Moody s equivalent credit rating. Data source: JPMorgan, Barclays. Data as of 31 December 2015 As of 31 December 2015, the JPMorgan Hard and Local currency indices yielded 6.4% and 7.1% respectively, significantly higher than the Barclays Global Aggregate index at 1.8%. The average credit quality of EMD has improved over the last few years and JPMorgan indices in aggregate now all have investment grade ratings. The opportunity set has expanded in terms of geographical location of issuer and amount of debt outstanding. For example, the JPMorgan EMBI Global Diversified index now covers 65 countries compared to 33 a decade ago. Aon Hewitt Actively Emerging: Opportunities in Debt 3

4 Emerging Market Debt risk factors Similar to debt issued by developed economies the principal risk for EMD investors is whether an issuer, be it government or corporate, will default on their debt obligations. Compared to developed markets, additional risks include greater political instability, more volatile domestic growth, exposure to commodity prices and exchange rate fluctuations. Furthermore, moves in US interest rates and currency impact the ability of EM issuers to repay their dollar denominated debt. While the market expects the pace of US interest rate rises to be gradual over the next few years, a more aggressive tightening by the Fed and subsequent rapid move higher in US treasury yields could draw capital out of risk assets like emerging markets. To compensate investors for the aforementioned risks, EMD offers a higher yield relative to developed market bonds (see Chart 1) and the spread between EMD and developed market bonds is close to the historic wides. Chart 1 - EMD vs. DM Yield (%) EMBI Global Diversified (Hard) GBI-EM Global Diversified (Local) CEMBI Broad Diversified (Hard) Barclays Global Aggregate 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 01/ / / / / / / / / / / / / / / / / /2015 Data source: JPMorgan, Barclays. Data as of 31 December 2015 The matrix on the next page shows the correlation of returns between EMD and other asset classes, which helps to identify where an allocation to EMD has the potential to provide diversification benefits. We highlight the following: EMD, particularly Local, has a low positive correlation with US Treasuries (Hard = 0.24, Local = 0.09 and Corporate = 0.17). The correlation between returns of Hard EMD and Equities is marginally lower than that between High Yield and Equities EMD (0.58 vs. 0.73). Whilst inter EMD sector correlation is relatively high, a blended EMD portfolio can still provide some diversification benefits. Aon Hewitt Actively Emerging: Opportunities in Debt 4

5 EMBI Global Diversified (Hard) GBI-EM Global Diversified (Local) CEMBI Broad Diversified (Hard) US Investment Grade JPM High Yield Euro Investment Grade US Treasuries S&P 500 EMBI Global Diversified (Hard) 1.00 GBI-EM Global Diversified (Local) CEMBI Broad Diversified (Hard) US Investment Grade JPM High Yield Euro Investment Grade US Treasuries S&P Source: JP Morgan, Data as of 31 December 2015 Historical performance Over the last 12 years EMD total cumulative returns compare favourably to Global Aggregate returns (see Chart 2). Chart 2 Total cumulative returns (%) 140% EMBI Global GBI-EM Global Diversified CEMBI Broad Diversified Barclays Global Aggregate 120% 100% 80% 60% 40% 20% 0% -20% Data source: JPMorgan, Barclays, Data as of 31 December 2015 Even over the last few years when China s economy has been slowing and commodity prices have been falling, Hard EMD generally performed in line with the Barclays Global Aggregate. This is largely due to the higher coupons on EM bonds offsetting adverse spread movements. Local sovereign debt, however, has underperformed Hard debt primarily due to local currency depreciation. The improved employment outlook and supportive economic data out of the US has increased the probability of tighter monetary conditions which has in turn led to an increase in the value of the dollar. The appreciation of the dollar also makes it more expensive to service Hard EMD, although export focussed EM corporates will benefit from more competitive exchange rates. Aon Hewitt Actively Emerging: Opportunities in Debt 5

6 Emerging Market Debt dispersion Socio-political and macroeconomic considerations will impact EMD across sovereign and corporate universes. Active managers are able to exploit these resulting idiosyncratic opportunities that exist across emerging markets. Chart 3 shows the dispersion of calendar year 2015 returns across a number of emerging markets. Ukraine was the top performer in Hard currency as the government reached a bondholder friendly restructuring agreement with creditors during the third quarter of Brazil was a notable underperformer across all EMD sectors following downgrades by S&P and Moody s linked to a deteriorating fiscal situation and political instability. Weakness in commodities, including oil drove underperformance for net exporters such as Colombia and Mexico. Chart 3 - Calendar Year 2015 Total returns (%) EMD (Hard) EMD Corporate EMD Local 45% 40% 35% 30% 25% 20% 15% 10% -10% -5% 0% 5% -15% -20% -25% -30% -35% Ukraine Argentina Russia Hungary Poland Turkey Mayalsia Indonesia Chile Peru South Africa Mexico Colombia Brazil Source: JPMorgan, Data as of 31 December 2015 Portfolio construction and implementation Our primary recommendation for clients who would like to invest in EMD is to engage an active manager. Passive EMD offerings are sparse and with a 20 to 30bps fee differential are not materially cheaper relative to active EMD products. Furthermore, given the wide dispersion in performance within the EMD opportunity set, active managers are able to build portfolios which can mitigate drawdown risk and capitalise on attractive investment opportunities as they arise. EMD strategies can be accessed through the following approaches: Sector specific and blended funds Separate managers can be appointed to run Hard, Local and Corporate EMD funds. Alternatively a single fund manager can invest across these EMD sectors through a Blended fund. For Sector Specific funds, managers can typically take off-benchmark positions, e.g. managers who run Local EMD funds can have exposure to Hard EMD. Aon Hewitt Actively Emerging: Opportunities in Debt 6

7 Unconstrained Emerging Market Debt strategies EMD-specific Absolute Return and Total Return funds typically fall under the unconstrained umbrella. Portfolio managers are not tied to a benchmark and are able to construct portfolios as they see fit in order to achieve their performance and risk objectives. Unconstrained fixed income strategies These include Absolute Return, Total Return or Multi Asset Credit funds. Managers for these products have the toolkit to tactically shift allocations between EMD and developed bond sectors and minimise losses as well as capitalising on idiosyncratic opportunities amidst changeable markets. We recommend speaking with your consultant to understand how your portfolio is positioned and how best to benefit from EMD opportunities. Contact Kareena Moledina +44 (0) kareena.moledina@aonhewitt.com Rohit Kapur +44 (0) rohit.kapur@aonhewitt.com About Aon Hewitt Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is a global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit: aonhewitt.com Follow Aon on Twitter: twitter.com/aon_plc Sign up for News Alerts: Aon Hewitt Actively Emerging: Opportunities in Debt 7

8 About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance brokerage and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 72,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions. For further information on our capabilities and to learn how we empower results for clients, please visit: This document and any enclosures or attachments are prepared on the understanding that it is solely for the benefit of the addressee(s). Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated to anyone else and, in providing this document, we do not accept or assume any responsibility for any other purpose or to anyone other than the addressee(s) of this document. Notwithstanding the level of skill and care used in conducting due diligence into any organisation that is the subject of a rating in this document, it is not always possible to detect the negligence, fraud, or other misconduct of the organisation being assessed or any weaknesses in that organisation s systems and controls or operations. This document and any due diligence conducted is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties (including those that are the subject of due diligence) and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by third parties (including those that are the subject of due diligence). This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinions or assumptions in this document have been derived by us through a blend of economic theory, historical analysis and/or other sources. Any opinion or assumption may contain elements of subjective judgement and are not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance. Views are derived from our research process and it should be noted in particular that we can not research legal, regulatory, administrative or accounting procedures and accordingly make no warranty and accept no responsibility for consequences arising from relying on this document in this regard. Calculations may be derived from our proprietary models in use at that time. Models may be based on historical analysis of data and other methodologies and we may have incorporated their subjective judgement to complement such data as is available. It should be noted that models may change over time and they should not be relied upon to capture future uncertainty or events. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: Registered Office: The Aon Centre The Leadenhall Building 122 Leadenhall Street London EC3V 4AN Copyright 2016 Aon plc aon.com Risk. Reinsurance. Human Resources.