Aon Hewitt Retirement and Investment Actively Emerging: Opportunities in Debt Risk. Reinsurance. Human Resources.
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
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) 397 599 376 42,952 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 65 15 50 73 Duration (years) 6.7 4.8 4.7 6.6 *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
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% 01/2006 08/2006 03/2007 10/2007 05/2008 12/2008 07/2009 02/2010 09/2010 04/2011 11/2011 06/2012 01/2013 08/2013 03/2014 10/2014 05/2015 12/2015 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
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) 0.79 1.00 CEMBI Broad Diversified (Hard) 0.93 0.72 1.00 US Investment Grade 0.70 0.50 0.70 1.00 JPM High Yield 0.78 0.66 0.81 0.51 1.00 Euro Investment Grade 0.53 0.69 0.48 0.43 0.36 1.00 US Treasuries 0.24 0.09 0.17 0.57-0.21 0.25 1.00 S&P 500 0.58 0.66 0.60 0.26 0.73 0.44-0.27 1.00 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% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 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
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 2015. 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
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)20 7086 2925 kareena.moledina@aonhewitt.com Rohit Kapur +44 (0)20 7086 9452 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: http://aon.mediaroom.com/index.php?s=58 Aon Hewitt Actively Emerging: Opportunities in Debt 7
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