The investment case for emerging-markets fixed income

A prominent investment firm explains why this asset class deserves more Canadian love

The investment case for emerging-markets fixed income
Given the low yields that still prevail around the world, European and US pension investors have been allocating more of their risk budgets to emerging-markets (EM) fixed income. By comparison, demand among Canadian investors has been more muted — and one firm says that should change.

“We believe Canadian investors have scope to increase their exposure for several reasons,” said PIMCO in a recent strategy note.

The firm noted that prospective returns from EM assets are still expected to more than compensate for the investment risks. The gap in realized growth between EM and developed markets has widened, according to PIMCO, and it expects the trend to be supported by the Chinese, Brazilian, Russian, and Mexican economies. The risk premium for EM fixed-income assets — which accounts for wide-ranging assessments of creditworthiness, varied bankruptcy protections, and other factors — is also expected to persist.

EM asset valuations also remain attractive. Based on large nominal and real rate advantages and undervalued currencies, PIMCO found local EM bonds to be more compelling investments than Canadian government bonds. They clarified, however, that investors should look at the segment as a long-term play, weathering some negative months or quarters to “capitalize fully on EM’s potential.”

Oil exporters tend to be affected negatively by declines in crude prices, but this doesn’t apply to all EMs. Citing a recent JP Morgan study, PIMCO said commodity exporters make up just under half of the EMBI Global Index; importers account for 30%, and around 20% don’t experience a meaningful effect from impacts to the commodity markets. “[W]e are more inclined to characterize the differentiated sensitivities of these countries as a source of potential alpha in an actively managed portfolio,” the firm said.

While EM investors have tended to favour equities because of their high return potential, PIMCO noted that “equity holders’ residual claims on earnings reside at the bottom of the capital structure.” On the other hand, the structural seniority and contractual cash flows characteristic of EM fixed income result in lower realized volatility, making it a good complement for EM equities.

That doesn’t mean EM fixed income is totally safe. PIMCO noted EMs’ historical tendency toward events like defaults, devaluation, and hyperinflation, as well as structural vulnerabilities like overreliance on commodities and weak institutions.

“[W]e believe high levels of country and credit differentiation in EM are of paramount importance,” the firm said.

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