Fixed income investors eye up emerging market debt to boost returns, says Invesco

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Eager APAC and EMEA investors are driving a surge in emerging market debt allocation, with almost three quarters of investors now allocating toward the asset class, according to Invesco’s third annual Global Fixed Income Study. This figure has shot up, with just under half of investors reporting the same in 2018.

Invesco has published an in-depth report outlining sentiments discerned from interviews with 159 CIOs and fixed income asset owners globally.

The study surveyed fixed income investors across North America, EMEA and Asia-Pacific (APAC) with a combined AUM totalling USD20 trillion (as of December 31, 2019). Respondents included defined benefit and defined contribution plans, sovereign wealth funds, insurers, private banks, diversified fund managers, multi-managers, and model builders. 

As interest in EMD continued to grow, investors became more selective, shifting to country specific allocations

The study found another year of rising interest in emerging markets debt (EMD). A strong run, relatively attractive yields, and diversification have led investors to increase allocations to the sector.  72 per cent of investors now have an allocation versus the 49 per cent surveyed in the 2018 study – a 47 per cent increase. This has been driven by EMEA and APAC investors: 80 per cent and 89 per cent of investors, respectively, have allocations to EMD, compared to just 51 per cent in North America. Moreover, of those invested in EMD, the average allocation is much higher in APAC (7.2 per cent) and EMEA (6.5 per cent) than in North America (3.6 per cent).

Specialisation is also on the rise, especially among investors attracted by returns (rather than diversification), who prefer country-specific allocations (63 per cent). China is of interest to the 42 per cent of investors who now have an allocation, encouraged by the belief that the Chinese economy and political system offer unique diversification benefits and the lowering of barriers to investment: 62 per cent of investors believe access is less challenging than two years ago.

“With low yields on offer in their core portfolios, EMEA investors have piled into EMD to boost returns. 69 per cent of those invested in it have done so for returns, compared to just 25 per cent of North American investors, who tend to see EMD as a diversifier,” says Nick Tolchard, head of EMEA, Invesco Fixed Income.
“Moreover, investors are no longer thinking of EMD as a monolithic asset class. We’re now seeing increased interest in specific markets, which we see as a long-term trend. It’s notable that Chinese fixed income in particular is one of the best performing asset classes this year, beaten only by US Treasuries.”
ESG cements its place in Fixed Income
Fixed income investors have sharply increased ESG integration: 80 per cent of EMEA and 69 per cent of APAC investors incorporate ESG into their fixed income portfolios, up from 51 per cent and 38 per cent in 2019 respectively. Moreover, within these portfolios, EMEA investors have the highest proportion of investments covered by ESG considerations, with 34 per cent compared to 22 per cent (North America) and 19 per cent (APAC). North American investors have been the least enthusiastic adopters of ESG, with just 56 per cent incorporating it into portfolios. 

Gone are the days when investors viewed the adoption of ESG investing principles as a hindrance to investment performance. Only 3 per cent of our survey respondents held this view whereas half of them now consider informed assessment of issuer-related ESG risks as an important tool for investors to enhance their returns.  Specifically, issuers who fail to address environmental – the “E” – and governance – the “G” – concerns may face higher borrowing and refinancing costs, with clear implications for the valuation of these securities for investors. 54 per cent of respondents now believe ESG analysis can unlock hidden value within fixed income. 50 per cent of investors that have incorporated ESG within their fixed income portfolios cite return enhancement as a key driver.
EMEA investors have the most positive attitude of all regions surveyed: 52 per cent stated incorporating ESG into their fixed income portfolios helped returns whereas just 2 per cent stated it was a hindrance. EMEA investors are also most bullish about the future of ESG, with 34 per cent anticipating these considerations having a ‘much greater influence’ in three years’ time. Only 15 per cent of EMEA investors expected ESG to be no more influential than it is currently, the lowest proportion of all respondents.

“Many investors used to assume that integrating ESG would compromise performance, but attitudes have changed. Across all regions, very few investors report that it has hindered returns and, in the case of EMEA, a majority (52 per cent) have said that integrating ESG has improved them,” says Tolchard.

“Acknowledging the duty investors have to the environment and society they operate in, three-quarters (75 per cent) reference social responsibility as the main driver to integrating ESG factors within portfolios. Further, More than two-thirds (67 per cent) of investors cited stakeholder wishes as a key motivator behind their decision to integrate ESG, showing just how important this issue has become to asset owners and investors.”
New approaches help to address a bond market liquidity paradox

Asset owners were extending allocations to illiquid asset classes late in the cycle. Yet the majority (51 per cent) expressed concern around bond market liquidity, uncertain how bond markets would behave during more challenging periods with the introduction of regulations such as Dodd-Frank and the retrenchment of traditional market makers that followed the global financial crisis. The response in part has been increased interest in strategies that can help improve liquidity and reduce market risk such as block trading directly between customers via ETFs (used by 59 per cent of investors), credit portfolio trading (used by 30 per cent) and wider adoption (56 per cent) of fixed maturity strategies.
“Investors are concerned about liquidity and regulation, especially given the collapse in growth brought on by Covid-19,” says Tolchard. “Many are seeing fixed maturity strategies as a good way of harnessing additional liquidity premiums, while at the same time curbing costs and generating stable, predictable returns. We found 56 per cent of investors are using them, including 72 per cent of DC pensions and 66 per cent of insurers.”       
Greater caution in advance of market turmoil
Fixed income investors were becoming increasingly risk averse prior to the market turmoil Covid-19 unleashed in Q1 2020. Almost half (43 per cent) believed the end of the record-long economic cycle was a year or less away, with the consensus for a soft landing. 23 per cent identified a bond market bubble with just 29 per cent fearing a major collapse in bond prices. Central bank easing led to low and negative yields, driving some to take on additional risk to bolster returns and meet objectives. The research shows a market that was plagued by fear: fear of losing, but also fear of losing out. Despite some late cycle risk-taking, the confluence of end-of- cycle concerns and fears of trade wars may have translated into portfolios that were better protected from the current, unprecedented exogenous shock impacting markets today.    

“The perception that spreads were tightening drove many investors to cautious positions. Given what Covid-19 has done to the market, those investors may be relieved,” concludes Tolchard.

“However, not all investors were so cautious, meaning some are having to manage significant volatility in what would traditionally be seen as high-quality assets, such as consumer goods, oil and gas, and travel.”