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Record low and negative interest rates in developed economies are fuelling a ravenous search for yield that is forcing pension funds and other conservative institutional investors out of their comfort zones and into risky emerging markets, according to fund managers and analysts.
The reason for this has little to do with the attractiveness of EM investments. On the contrary, EM economic growth is at its lowest level since the 2008/09 financial crisis while the prospect of a US monetary tightening creates the potential for financial turbulence.
The force propelling pension funds and insurance companies into unfamiliar EM investments is simple. If they stay at home, their investment returns are at risk of falling short of their liabilities.
“If you require, say, 5 per cent a year in order to cover your insurance or pension liabilities, that is not available from developed market (debt) obviously,” said Colm McDonagh, head of emerging market fixed income at Insight Investment.
Brett Diment, head of emerging market debt at Aberdeen Asset Management, also sees a diversification into EM debt by pension and insurance companies. “We are seeing a broader group of investors looking at the emerging market debt asset class, including some insurers and pension funds that have not looked before.”
Much of this search for yield takes place behind the scenes, but it is not restricted to developed markets, where an estimated $1.7tn in bonds were offering negative yields last month. South Korea’s state-run National Pension Service (NPS) announced this week that it would pour more than $40bn into overseas equities and bonds over the next five years.
The NPS, which manages $483bn and is the biggest investor in the Seoul market, had “no choice” but to look abroad for returns, according to the Korea Times, because domestic interest rates are low and set to fall further.
Paolo Batori, global head of EM fixed income strategy at Morgan Stanley, foresees a fundamental shift in market dynamics. He said about 5 per cent, or $80bn, invested by insurance companies and pension funds in European government bonds would be switched into EM fixed income. Such an increase would roughly double the current exposure of such companies to emerging markets.
Mr Batori uses the experience of Japanese life insurance companies after Japanese government bond yields declined in the aftermath of the financial crisis to reinforce his forecast. From the first quarter of 2009 to the third quarter of last year, Japanese life insurance companies increased their investments in foreign assets from just over Y15tn to nearly Y35tn as their search for yield intensified.
But where in EM should yield refugees from Europe go? In one sense, there is plenty of potential; emerging market countries account for around 40 per cent of global GDP but only 14 per cent of the global government bond market by value. And differences in yield are stark.
“In aggregate, (local currency emerging market debt) yields 6.5 per cent — just above the average for the last five years, and a full 1.25 percentage points above the level preceding the May 2013 taper tantrum,” said Denise Prime, an investment manager at GAM.
“With former safe havens looking so unappealing, local-currency emerging market debt is an attractive option for fixed-income investors,” she added.
But, of course, yields such as these do not come without risk. One of the biggest concerns is that when the US Federal Reserve tightens its monetary policy — though the timing for this is uncertain — funds could exit EM assets in favour of enhanced returns in the US.
The most vulnerable EM countries in such a scenario would be those that run hefty current account deficits and are therefore reliant on external financing. Such risks have been so well telegraphed that fund managers generally pursue a highly selective approach to EM assets.
One of the strategies deployed by investors to mitigate the risks of a strong dollar is to fund investments not by borrowing US dollars but euro, which has depreciated or stayed steady against many EM currencies. In 2014, local EM currency bonds returned an average 7 per cent against the euro and have returned 7.3 per cent this year so far, according to Ms Prime.
Another scheme to defray EM risk is to select the bonds of investment-grade issuers only, thus qualifying for inflows from insurance companies and pension funds that are restricted by their covenants from investing in issues designated as ‘junk’.
In a separate category, a large but relatively untapped opportunity lies in China. Some $1.5tn of the $4tn global market for EM local currency bonds is located within China’s domestic market, accessible to foreign investors only through a tightly controlled quota system.
But for those investors able to access allocations, the returns can be attractive because of the higher interest rate environment in mainland China. The China Universal Enhanced Bond Fund, for example, returned 13.12 per cent in 2014, according to China Universal, a Chinese asset manager.
“We are definitely seeing increasing interest from European investors, both retail and institutional, who are hunting for yield in a world that is not really delivering their return targets,” said Christopher Gunns, a managing director at China Universal.
But, he notes that Chinese domestic debt stretches the comfort zone for some European investors. “Among the institutional investors there are two things at play; a conservative risk budget competing with a need to generate returns.”