SEEKING OUT RISK PREMIA IN EMERGING MARKET DEBT

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1 FOR PROFESSIONAL CLIENTS ONLY. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL. PLEASE REFER TO ALL RISK DISCLOSURES AT THE BACK OF THIS DOCUMENT. SEEKING OUT RISK PREMIA IN EMERGING MARKET DEBT FEBRUARY 2018 > Emerging market debt investors enjoyed strong performance in In 2018, we expect improving economic fundamentals and supportive technicals to continue to underpin the asset class. Although volatility is likely to increase given upcoming elections, growing protectionism and global monetary policy normalisation, this could reward those willing to take a more active approach to asset allocation and country/security selection.

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3 SEEKING OUT RISK PREMIA IN EMERGING MARKET DEBT 2017 WAS A YEAR TO REMEMBER FOR EMERGING MARKET DEBT INVESTORS, CHARACTERISED BY LOW LEVELS OF VOLATILITY AND STRONG RETURNS AS RISK PREMIA COMPRESSED ACROSS THE ASSET CLASS. WHILE THIS IS UNLIKELY TO REPEAT IN 2018, WE BELIEVE PLENTY OF ATTRACTIVE INVESTMENT OPPORTUNITIES REMAIN, MOST NOTABLY IN LOCAL RATES AND CORPORATE DEBT A TESTAMENT TO THE BREADTH AND DEPTH OF THE ASSET CLASS. WITH VOLATILITY LIKELY TO PICK UP OVER THE YEAR, WE EXPECT PERFORMANCE DISPERSION TO CREATE INCREASED OPPORTUNITY. INVESTORS WILL NEED TO BE MORE DISCERNING HOWEVER: ASSET ALLOCATION AND COUNTRY/SECURITY SELECTION WILL BE CRUCIAL. EMERGING MARKET DEBT INVESTORS HAD A LOT TO BE THANKFUL FOR IN 2017 The stars were in near-perfect alignment for Emerging Market Debt (EMD) investors in Volatility remained anchored at historically low levels and record-breaking investor inflows contributed to strong returns across the EMD complex (Figure1). It was an environment that provided investors with significant opportunities to take advantage of the attractive risk premia on offer; a year in which sovereign and corporate spreads tightened by 57 basis points (bp) and 43bp respectively and local currency yields ended 65bp lower (Figure 2). Figure 1 A look back on 2017: Risk assets outperform 1 Asset class EM Equities US Equities EM Local Currency Debt (USD, unhedged) EM Hard Currency Sovereign EM Hard Currency Corporate EM Local Currency Debt (rates only) US High Yield Euro High Yield US Investment Grade EM Local Currency Debt (FX only) Global Investment Grade Euro Investment Grade US Treasuries EM Local Currency Debt (EUR, unhedged) n EMD n Non EMD Performance return (%) Figure 2 EMD sub-asset classes experienced good risk-premium compression in Spead (bp) Yield (%) 250 Jan 17 Apr 17 Jul 17 Oct 17 EM corporate spread (LHS) EM sovereign spread (LHS) EM local yield (RHS) 5.5 Jan 18 1 Source: JPMorgan, Insight Investment, 31 December 2017.

4 STRUCTURAL AND CYCLICAL FACTORS UNDERPIN THE ASSET CLASS A combination of structural and cyclical considerations continues to drive this positive dynamic. From a structural standpoint, EMD remains in the grip of two key trends positive growth rerating and increasing allocations to the asset class by under-allocated institutional investors. While the rerating trend has paused, or in the case of emerging market sovereigns undergone a modest reversal in recent quarters, the broad and enduring structural trend remains one of positive ratings progression. And in terms of institutional demand, we expect these investors to continue to add exposure to the asset class as the improvement in emerging market fundamentals encourages more of them to commit an allocation to the asset class. THE GLOBAL ECONOMY IS IN THE MIDST OF A SYNCHRONISED CYCLICAL UPSWING On the cyclical front, in 2017, the synchronised upswing in global economic activity quickened, leading the International Monetary Fund (IMF) to upgrade its global growth forecasts. Improving growth was a boon for commodity exporters across the emerging market complex, and particularly in Latin America, as prices have rebounded for both industrial metals and energy. Emerging market manufacturers also benefited from a recovery in trade activity, with the World Trade Organisation (WTO) estimating growth in global goods trade of 3.6% for Meanwhile, developed market inflation the UK a notable exception was conspicuous once more by its absence over the year. This has allowed key G4 central banks to approach the process of policy normalisation in a gradual and measured manner. The Federal Reserve implemented three hikes through 2017 and commenced the process of balance sheet reduction in October, while the European Central Bank has only just started to taper its asset purchases and has yet to hike its policy rate. However, this start to central bank policy normalisation did little to dampen investor sentiment. Not even regular bouts of geopolitical sabre-rattling between the United States and North Korea were sufficient to cause a ripple in markets.

5 WHERE TO FIND ATTRACTIVE RISK PREMIA IN EMERGING MARKET DEBT TODAY? After a year of strong spread and yield compression and solid returns, the obvious question to ask for 2018 is whether there are any pockets of attractive risk premia left in EMD. The good news hopefully unsurprising given the breadth and diversity of the asset class is that EMD continues to offer potentially attractive opportunities across the spectrum of local rates, currency and sovereign and corporate credit, in our view. We would highlight that while 2017 might be described as a beta year, with broad-based risk premia compression, we believe 2018 is less likely to be a repeat. Investors may need to be a lot more discerning in order to uncover pockets of attractive risk premium. In other words, asset allocation and country/security selection will be crucial. A comparison of real yields relative to associated credit spreads across key EMD markets (see Figure 3) suggests that real interest rates are still compelling across many local markets, especially in an environment where attractive yield remains a rare commodity. This chart also indicates that a number of markets offer considerable credit risk premium. This pick-up in credit premium can be explained in part by the very busy electoral cycle across emerging markets in 2018, with some elections having the potential for destabilising outcomes. Mexico and Brazil are two such examples (discussed below). Looking at Figure 4 which plots emerging market real yields against the respective 2s10s 2 curves we can also make a number of interesting observations. Comparing real yields against the respective yield curves illustrates that against a backdrop of an aggressively flattening US treasury yield curve, EMD yield curves are very attractive across a number of markets such as Brazil, Colombia and Chile, which have offered a spread premium of close to, or above, 150bp. Figure 3 Real yields versus credit spreads 3 5-year real yield (%) India Peru Korea Poland Chile Philippines Thailand Israel Malaysia Czech Republic Hungary Romania Russia Indonesia China Colombia Brazil Mexico South Africa Turkey Argentina Spread (bp) Figure 4 Real yields versus curve steepness 2 5-year real yield (%) Turkey Mexico Russia India South Africa Colombia Peru Indonesia Philippines Chile Korea Thailand Israel Poland Malaysia Hungary Romania Czech Republic Brazil year 2 year yield differential (axis trimmed at -200) 2 10 year - 2 year yield differential. 3 Source: Insight Investment, Bloomberg, 20 February 2018.

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7 In emerging market corporate debt we see plenty of risk premia opportunities. Both high yield and investment grade debt offer, in most instances, a premium over their developed market equivalents when taking duration into account (see Figure 5). Figure 5 Yield versus duration across asset classes 4 We see plenty of risk-premia opportunities in emerging market corporate debt with both high yield and investment grade offering a premium over their developed market equivalents. Yield (%) 8 7 US HY (B+) 6 5 EM HY (BB) 4 EM IG (BBB+) 3 Euro HY (BB-) 2 US IG (A-) Euro IG (A-) Duration (years) n US n EM However, opportunities in corporate debt will vary across regions, maturities and sectors. The spread per turn of leverage (which reflects how much additional spread is on offer for the amount of leverage on a corporate issuer s balance sheet) is materially higher for emerging market corporate debt relative to comparably-rated US corporates (see Figure 6). The notable exception is B-rated debt an effective reminder of the need to take a selective approach to the asset class. Figure 6 Spread per turn of leverage (EM versus US corporates) 5 Spread per turn of leverage A BBB BB B n US n EM 4 Source: Bloomberg, Insight Investment, Bank of America Merrill Lynch as at 31 January Source: Bloomberg, Insight Investment, Bank of America Merrill Lynch as at 31 December 2017.

8 WHAT ARE THE RISKS TO WATCH FOR IN 2018? We believe many of the structural and cyclical factors discussed above will continue to remain relevant throughout The synchronised recovery in global growth appears increasingly resilient, emerging market macro fundamentals continue to improve and investor appetite shows little sign of diminishing. That said, we see a number of risks both domestic and exogenous to emerging markets that warrant monitoring. Local politics Emerging markets enter a congested and potentially volatile political cycle in 2018, and this will require a particularly selective approach to risk premia in markets as diverse as Brazil, Mexico, Colombia, India and Indonesia (see Figure 7). Volatility could roil Brazil s markets ahead of the October presidential election, where there is substantial risk of no centrist candidate progressing to the runoff vote. The leftist candidate and former president, Luiz Inacio Lula da Silva, leads polls by a wide margin despite his candidacy looking less viable following the upholding of his graft conviction in January. At risk here is the progress made to date in advancing structural reforms, fiscal adjustment measures and sustainable growth policies; policies that have helped deliver Brazil s nascent economic recovery. In Mexico, hard-left presidential candidate Andrés Manuel López Obrador s lead in the polls has worried some investors that his victory would herald an era of regressive policies that would ultimately weaken institutions and roll back reforms. We believe that in the case of Brazil and Mexico, and in several other emerging markets, the risk of disruptive and destabilising electoral outcomes justifies the additional risk premium on offer in these markets. Exogenous risk factors We note three exogenous risk factors that warrant close attention from investors: central bank balance sheet normalisation, upward repricing of US interest rates and protectionism. With the Fed in the process of winding down its balance sheet and likely to chalk up a number of further hikes throughout 2018, and with the ECB reducing its asset purchases from January onward, the forward march of global monetary policy normalisation has the potential to create some volatility for EMD. While gradual and well-telegraphed normalisation of central bank policy remains our base case, the risk remains that balance sheet adjustments prove disruptive for markets. Furthermore, with the US economy likely to grow above potential over coming quarters, the prospect of higher-than-expected inflationary pressures leading to an upward repricing of US rates should not be discounted. Lastly, there remains a risk that protectionist policies relating to global trade increase over Such a development could have a negative impact on global growth and serve as a catalyst for spikes in the volatility of floating currencies. Figure 7 Emerging markets election calendar has an impact on risk premia 6 India and China Dec Jan Thailand Nov Feb Indian and Taiwan Venezuela and Brazil Oct Sep 2018 Mar Apr Indonesia, Russia, Korea and China Russia, India and Hungary Indonesia and Malaysia Aug May Colombia Mexico Jul Jun Colombia, Indonesia and Philippines 6 Source: HSBC.

9 We believe many of the positive structural and cyclical factors affecting emerging markets will continue to remain relevant throughout That said, we see are a number of risks both domestic and exogenous to emerging markets that warrant monitoring.

10 Colm McDonagh, Head of Emerging Market Fixed Income Colm joined Insight in November 2008 as Head of Emerging Market Fixed Income, responsible for all emerging debt strategies. Prior to joining Insight Colm s previous roles included partner at Hydra Capital Management (an emerging market fixed income boutique) and Head of Global Emerging Market Debt at Aberdeen Asset Management. He began his career at Bank of America in 1996 as an emerging market Eurobond trader. He has invested across the wide spectrum of the asset class through long only and alternative strategies. Colm holds a B.B.L.S. honours degree in Finance and Law from University College, Dublin. IMPORTANT INFORMATION RISK DISCLOSURES Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations. ASSOCIATED INVESTMENT RISKS Fixed income Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade. The issuer of a debt security may not pay income or repay capital to the bondholder when due. Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise. Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio. Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio. The investment manager may invest in instruments which can be difficult to sell when markets are stressed.

11 FIND OUT MORE Institutional Business Development European Business Development Consultant Relationship Management Client Relationship Management company/insight-investment This document is a financial promotion and is not investment advice. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment. Issued by Insight Investment Management (Global) Limited. Registered office 160 Queen Victoria Street, London EC4V 4LA. Registered in England and Wales. Registered number Authorised and regulated by the Financial Conduct Authority. FCA Firm reference number Insight Investment. All rights reserved

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