Emerging market debt (EMD) has already broadened and deepened significantly in the last few decades and as the asset class has developed, it has become more appealing to a broader investor base. Issuance has increased, thereby improving liquidity. Yield curves have become more developed, allowing active investors to add value via positioning across different maturities.

As these factors have improved, the ownership mix has diversified, with a greater balance between foreign and domestic owners. This trend looks set to continue over the next decade. As this happens, it will be more important than ever to access the market proactively.

One benefit of an active approach is access to a wider source of returns, given the ability to take exposure from outside the index’s universe, and use multiple levers to capture different drivers of return and manage risk. There are also benefits to having a more deliberate allocation of capital, which could mitigate unintended consequences of index construction.

 

Broadest possible universe

Certain indices restrict the opportunity set available due to construction methodologies and constraints. This can be to the detriment of passive investors, as their exposure is (perhaps unintentionally) restricted to only a limited sub-set of the emerging market debt universe, which has been pre-selected by the index providers. Access to a broader range of markets and instruments could offer increased and more varied sources of alpha and can help to provide greater diversification. We have seen many frontier markets take advantage of low global interest rates to start to issue debt in international capital markets, and we can expect this trend to continue over the next decade. Many frontier markets, along with China and India, are examples of countries offering potentially attractive investment opportunities, with limited representation in the major 

EMD indices. As a result, foreign ownership of bonds has generally been low in these countries.

 

More deliberate allocation of capital

An active approach offers a more deliberate allocation of capital and can help mitigate some of the unintended consequences of index construction methodologies. The starting point for the construction of an EMD index remains the level of sovereign debt outstanding (and so the more debt that a country has, the greater its weight in the index) and as index composition evolves and is rebalanced, the exposure provided by a passive strategy will shift accordingly. As some EM countries have been building up debt levels again amid the recent pandemic, we could see countries with unsustainable debt gaining greater representation in the EM debt indices. 

On a related note, the anticipation of technical market factors could offer active investors an information advantage over passive strategies, as the movement of countries into and out of indices can have dramatic effects on the balance of market demand and supply.  

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.