Emerging Market Debt To hedge or not to hedge? November 2019 Amid persistent low interest rates in developed countries, Emerging Market Debt offers investors diversification and the potential for attractive returns. Snapshot of Emerging Market Debt Emerging Market Debt (EMD) is often considered a complex asset class because it incorporates four bond sectors and currencies in over 40 countries. However, it is precisely these characteristics that present significant opportunities for Australian investors. Persistent low interest rates in developed countries offer the potential for meaningful diversification and highly attractive returns, making EMD a potentially valuable addition to an investment portfolio. The EMD asset class can be broadly divided into Local Currency and Hard Currency Debt, also known as External Debt. These categories can then be further divided into Sovereign Bonds and Corporate Bonds. We’ve provided descriptions of these sectors in the table below. Local Currency The largest and most liquid sector of EMD. It offers attractive yields in Sovereign Debt countries with developing capital markets and is often uncorrelated to and Local Currency developed market interest rate cycles. Corporate Debt Local Debt can be held along with currency exposure, or the currency can be hedged, although hedging can partially or completely negate the additional yield. This sector displays higher volatility and highly differentiated returns, so active management is advisable. Hard Currency These are bonds issued by emerging market countries in hard currencies, Sovereign Debt predominantly in USD. This sector is less volatile than Local Debt due to the lack of emerging market currency risk. These countries tend to have lower credit quality than local currency countries on average and therefore are considered a credit allocation. This sector has suffered deteriorating secondary market liquidity as brokers have, since the financial crisis, been unwilling to devote capital to supporting these markets. Hard Currency The fastest growing sector of EMD. Hard Currency Corporate Debt can Corporate Debt occasionally have a higher credit rating than the country where it is based and can offer USD bond access to countries that do not need to issue USD sovereign debt (e.g. China). However, this sector involves interest rate, spread and credit risk and generally very poor secondary market liquidity – particularly during periods of wider market sell-off. 1 Schorders: Merill Lynch 31 July, 2019; BIS – Triennial CB Survey 2016 Emerging Market Debt 2 In contrast to 20 years ago, Local Currency Debt is by far the largest sector EMD. Comprising 85% of the EMD market as at 31 July 2019, the Local Currency Debt sector is split almost equally between Sovereign Debt and Corporate Debt, at 43% and 42% respectively. 1 Of the remaining 15% of the EMD market, 10% is made up of Hard Currency Sovereign Debt and 5% of Hard Currency Corporate Debt.1 Growth in local market issuance Total universe by sector and region 30,000 30,000 30,000 30,000 30,000 10% 10% 16% 16% 5% 5% 30,000 10% 16% 5% 20,000 20,000 43% 43% 50% 50% 20,000 43% 23% 23% 50% 23% 15,000 15,000 42% 42% 11% 11% 15,000 42% 11% 10,000 10,000 10,000 Ext corp debtExt corp debtLocal corp debtLocal corp debt Latam Latam EME EME 5,000 5,000 Ext corp debt Local corp debt Latam EME Ext govt debtExt govt debtLocal govt debtLocal govt debt sia (ex China)sia (ex China)China China 5,000 Ext govt debt Local govt debt sia (ex China) China 0 0 Local debtLocal = 85% debt = 85% 2001 20032001 20052003 20072005 20092007 20112009 20132011 20152013 20172015 20192017 2019 EMD issuanceEMD total: issuance US 26.3 total: trillion US 26.31 trillion1 0 Local debt = 85% 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 ExternalExternal debt = 15% debt = 15% EMD FEMD average issuanceEMD dailyF averagetotal: turnover: US daily26.3 US1.66 turnover: trillion trillion1 US1.662 trillion2 Local SovereignLocal SovereignLocal CorporateLocal CorporateExternal SovereignExternal SovereignExternal CorporateExternal Corporate External debt = 15% EMD F average daily turnover: US1.66 trillion2 Local Sovereign Local Corporate External Sovereign External Corporate Source: Schroders; 1Merill Lynch - 31 July 2019. 2BIS - Triennial CB Survey 2016 Local Currency Sovereign Debt is available from a wide range of emerging market countries. Unlike external sovereign debt, which is primarily a credit play, local currency bonds remain largely driven by views on local inflation and local interest rates. As the chart below shows many of these still offer attractive real yields (after inflation) in comparison to developed market bonds where real yields are either very low or negative. As these economies mature, inflation is expected to fall causing rates to converge downwards over time, similar to what occurred in South Korea and Taiwan. Real Yields 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% India Peru Chile Russia Brazil China Israel Japan MexicoS Africa Turkey S Korea TaiwanCanadaPoland France Malaysia Colombia Thailand Australia HungaryGermany Indonesia Philippines Singapore United States United Kingdom Source: Bloomberg/Schroders Currency exposure: to hedge or not to hedge? One of the main considerations with investing in EMD is deciding how to manage the currency exposure. For Australian investors, hedging allocations to USD-denominated Sovereign and Corporate Bonds back to AUD has made sense in recent years. While the USD hedging cost has increased, it remains low at less than 1%. When it comes to investing in Local Currency Debt, the investor must decide between: – hedging the emerging market currency exposure (passively hedged); – hedging the whole allocation as a USD exposure (given this is likely the base currency of the vehicle they are using); – leaving the exposure unhedged; or – leaving the allocation unhedged and actively managing the currency exposure. Each approach brings an entirely different risk/reward dynamic. We’ll discuss the implications of each option in turn. Emerging Market Debt 3 Option 1 – Passively hedged Typically, investors allocate to emerging markets to benefit from the far higher yields available in local currency bonds. For example, as at October 2019, Mexico is rated A- by S&P, which is the same credit rating as Spain, but Mexico’s 10-year government bond yields around 7% in local currency terms versus Spain’s paltry 0.2%. Passively hedging emerging market FX is expensive and would cost on average around 4.5% p.a., using the Bloomberg Cumulative EM-8 Carry Trade Index, plus USD to AUD hedging costs as a proxy. Using the Mexico and Spanish 10-year government bonds as an example, if an Australian investor hedged the currency back to AUD it would reduce Mexico’s hedged yield to a mere 0.2% and see Spain’s hedged yield jump to a more attractive 2%. As the chart below shows, this approach removes most of the attractive yield on offer from Local Currency EMD. However, this doesn’t mean that all Local Currency EMD looks unattractive on a passively-hedged basis. Most investments will still yield more than their developed market counterparts after hedging (Germany, Australia and the US included below for reference). Plus, given higher real yields, they potentially offer more chance of capital appreciation because yields have more room to compress. Emerging market local currency bonds net yield hedged to AUD 20.00% 15.00%20.00% 10.00%15.00% 10.00%5.00% 0.00%5.00% -5.00%0.00% 3.75% 3.25% 3.23% 3.12% 2.13% 1.67% 1.64% 1.63% 1.57% 1.51% 1.38% 1.26% 1.17% 1.14% 1.08% 0.86% 0.73% 0.71% 0.71% 0.71% 0.71% -10.00%-5.00% 3.75% 3.25% 3.23% 3.12% 2.13% 1.67% 1.64% 1.63% 1.57% 1.51% 1.38% 1.26% 1.17% 1.14% 1.08% 0.86% 0.73% 0.71% 0.71% 0.71% 0.71% -15.00%-10.00% -20.00%-15.00% -20.00% Peru (A-) Brazil (BB-) Chile (AA-) Poland (A) China (A+) Malaysia (A) Turkey (BB-) India (BBB-)Mexico (A-) S Africa (BB+) Taiwan (AA-) S Korea (AA)Russia (BBB) Thailand (A-) Hungary (BBB) Peru (A-) Australia (AAA) Brazil (BB-) Colombia (BBB)Chile (AA-) Poland (A) Germany (AAA)China (A+) Indonesia (BBB) Malaysia (A) Turkey (BB-) India (BBB-)Mexico (A-) S Africa (BB+) Taiwan (AA-) Philippines (BBB+)S Korea (AA)Russia (BBB) Thailand (A-) Hungary (BBB) Australia (AAA) United States (AA+) Colombia (BBB) Germany (AAA) Indonesia (BBB) Philippines (BBB+) United States (AA+) Local Hedge ot Yield Local Hedge ot Yield Source: Bloomberg Alternatively, investors can choose to invest in higher-quality emerging markets – such as Korea, Taiwan, Malaysia, Chile and Poland. These markets offer similar portfolio protection to other Sovereign Bonds in the developed world, plus slightly higher hedged yields. This will allow a greater yield pick-up than simply investing in developed market Sovereign Bonds, however investors will lose the potential return advantages and diversification benefits of unhedged local currency exposure. Option 2 – Hedged as a USD exposure Most views on emerging market currencies are relative to the USD, which makes the task more complicated for non-USD investors. This can often dissuade investors, as they don’t believe they have the expertise to determine the attractiveness of emerging currencies versus their base currency. Alternatively, they may believe that by simply hedging the overall exposure as a USD investment, it’s possible to receive the investment return outcome experienced by a USD investor without worrying about the base currency. While there is logic in the latter, Australian investors would be giving up potential return and diversification benefits in doing so. Emerging Market Debt 4 Option 3 – Unhedged An option chosen by many investors is to leave the currency unhedged to take advantage of the higher yields available in emerging markets.