Play emerging markets with debt

The rapid recovery from the global downturn seen in emerging markets, coupled with their strong economic fundamentals and often-favourable demographics, has given investors the taste for the developing world's growth story. For most investors, the first port of call will be emerging market equities, either through an exchange-traded fund or an actively-managed fund. But there is another way of playing the emerging markets growth story: emerging market debt in the local currencies.

As an asset class, local-currency emerging-markets debt (bonds issued by emerging-market institutions in their own currencies) has delivered superior risk-adjusted returns. Over the 16 years stretching from 1993 to December 2009, local-currency emerging-markets debt has returned 11 per cent a year to investors, with volatility of only 9 per cent. Over the same period, global emerging market equities returned almost half this rate — 6.1 per cent — coupled with volatility of 25 per cent.

"Emerging markets' local currency-denominated debt is a large and liquid asset class that offers the potential to generate equity-like returns without taking on direct equity risk," says Alexander Kozhemiakin, director of emerging markets strategies for Standish Mellon, the fixed-income division of BNY Mellon.

Local-currency debt offers the potential for capital gains from both bonds and currencies, which contributes to good, relatively stable returns for investors. Emerging market debt can also provide powerful diversification in a portfolio, given its relative lack of correlation to other asset classes. That said, there is the major risk of investing in currencies that could weaken against sterling.

One of the first funds to pioneer investment in locally-denominated debt is the Investec Emerging Markets Debt Fund. The fund, which recently celebrated its third anniversary with annualised returns of close to 15 per cent, invests in public-sector, sovereign and corporate bonds across a wide range of emerging markets.

Managed by Peter Eerdmans, the fund targets superior returns by investing in higher-risk emerging market debt with currency exposure, with the intent to capitalise on the stronger macro-economic and political environments. Consequently, the majority of its debt is lower investment grade, rated 'A' and 'BBB', with a good proportion of holdings in the junk category. This balance between higher-yielding debt and less risky investment-grade debt provides a solid platform for the fund to achieve its objective of superior returns.

Mr Eerdmans, who also heads the Investec Emerging Markets debt team, has 10 years experience in fixed-income markets. He says: "In our view, the credit crisis was primarily a developed market problem, while emerging markets were generally far less leveraged. This starting point should also support growth for the future." He adds that, while issuance of local-currency emerging-markets debt has grown rapidly over recent years, issuance in dollar debt has been dwindling. This combination of growth in demand and supply has led to improved liquidity in emerging market debt.

The fund has been the top performer in its sector since its launch, providing investors with a diverse geographical asset allocation and exposure to 16 different currencies (see table).

High returns mean high risk, of course. Emerging markets generally are more volatile than developed ones. Less ample liquidity can lead to bubbles and manias, such as in the early 1990s, and there is foreign-exchange risk, too. However, Investec has an established history in emerging market debt, with an investment process developed and refined over 18 years, plus 30 years' experience in global bond and currency markets. With an exposure to emerging markets increasingly seen as integral to market-beating performance, this interesting fund is a buy.

Source: Investec Asset Management, Morningstar*

Notes: Performance figures as at 21 January 2010

Top 10 holdings as at 31 December 2009

Credit breakdown