Capital Ideas^TM

EMD has become increasingly appealing to a broader investor base as the asset class has developed. Issuance has increased, thereby improving liquidity.

Yield curves have become more developed, allowing active investors to add value via positioning across different maturities. As both of these factors have improved, the ownership mix has diversified, with a greater balance between foreign and domestic owners. Indeed, the establishment of a mature local currency EM bond market and the effective management of interest rate policy are key indications of a country’s ongoing economic development.

The rationale for a strategic allocation to local currency EMD is strong given the diversification benefits and potential for strong returns driven by attractive yields; but how best to manage such exposure? An allocation to passive or smart beta strategies can provide an effective and low-cost way to access the broad market. However, these approaches can lead to exposure biased towards countries with higher levels of indebtedness, without considering the direction of travel with regards to economic policy. They can also restrict opportunities to capture relative value through market movement. Interest rate and exchange rate volatility can at times be high; an active approach can help to mitigate this.

It is important to think carefully about how best to gain exposure to this increasingly sophisticated market. In order to fully understand each market and assess which countries to allocate to and which to avoid, it is essential to conduct in-depth, fundamental research into individual countries’ rates and currencies, framed in the context of the global macro environment. As the opportunity set has developed, deep understanding of market technicals and trading strategies can further complement fundamental research to enable successful market execution and can have a significant impact on return. Similarly, robust risk management is essential.

We believe an active investment approach that is aware of the benchmark but not beholden to it, and draws on extensive research with disciplined risk control, offers investors the greatest opportunity to generate strong risk adjusted returns through shifting volatility regimes. Many investors we speak with share this view. According to a recent survey among UK asset owners, the majority of respondents believe that active strategies will add value over passive approaches in EMD, and almost 40% say they plan to increase the share of active management in their portfolios over the next 12 months.¹

In this paper we provide our philosophy behind this as well as explore what to look for when selecting an EMD manager.

1. Based on the Capital Group 2024 Fixed Income Horizons Survey which captures the views of 100 UK asset owners.