Emerging market sovereign debt presents an attractive investment opportunity with interest rates currently at historic lows, according to a panel at the Frontier Advisors annual conference.
Frontier Advisor’s Head of Fixed Income and Currency, Andrew Kemp, said US and Australian government bond yields have been slashed in the wake of the global financial crisis but emerging market yields remain largely unchanged.
“So when we have clients and prospects talking about how to navigate the low yield environment, emerging market debt still stands out as a powerful place to invest,” he said during a session at the annual conference.
The yield spread between Australian and emerging market sovereign debt is now at a record high.
“We think at this point in time it’s a great entry point at least on a relative value basis to discuss this.
It seems to us that the risks in emerging markets have reduced as well, so you’re getting more risk premium for less risk.” Australian Super also has a positive view of a structural long-term allocation to emerging market sovereign bonds.
“The higher quality emerging market economies are going to improve in terms of their credit quality and they’re going to experience that disinflationary trend through appropriate regulatory and governance as well as openness to trade,” said Katie Dean, Manager Fixed Income Strategy at Australian Super.
There is also a case for a cyclical allocation to emerging market sovereign debt but investors still need to consider volatility and currency risk.
“It’s not just as simple, particularly for an Australian dollar investor, as going out and buying an EM benchmark,” Dean said.
While inflation remains low in many developed economies, investors are now preparing for its gradual return – and showing some interest in inflation protection – as the US Fed slowly raises interest rates, according to Kemp.
Over the longer term, Frontier expects inflation to pick up as globalisation potentially declines in the face of more protectionist policies, economies shift to higher-cost services from manufacturing, and populations age.
“We still think central banks will be able to meet their inflation targets… our expectation over 5-10 years and even longer is that the RBA will still get to its 2.5 per cent inflation target but there is potential upside to inflation,” KC Low, Frontier Advisers Consultant said.
However, Dean said she was “less optimistic” that inflation would sustainably rise globally or in Australia over the short-term.
Kemp said inflation-linked bonds have worked well as an investment strategy but that was driven by a long-term downward trend in interest rates.
Inflation-linked bonds have historically underperformed relative to nominal bonds during growth shocks, such as the GFC. However, investors should consider holding a mix of both, funding inflation-linked bonds from nominal bond allocations.
“You should match the duration – don’t go into inflation-linked bonds now expecting some kind of outperformance especially if we’re in a rising rate environment.”
Investors should also consider the full curve of opportunities, with many bonds occupying the very long end of the yield curve, as well as global inflation-linked securities in light of Australia’s capacity issues.
Dean said the Australian Super views its fixed income allocation less as a defensive strategy and more as another source of growth.
“It’s challenging but it’s also exciting at the moment because it’s a good opportunity in the current market environment where things are looking quite fully priced to make returns through active management, which is what we’re very focused on.”
Australian Super employs two approaches: active duration management and allocating to market betas.
Dean said active duration management doesn’t necessarily mean setting long-short duration outright positions for your portfolio, which can be hard given it’s unclear whether the Trump presidency will be good or bad for inflation.
“But you can definitely do some very interesting cross-country active duration positioning at the moment which can be a very nice source of return for your portfolio.”
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