A structural shift in the global economic landscape may herald a turning point for local currency emerging market debt (EMD), according to a new report by investment consultancy bfinance.
The firm’s latest research suggests that declining US dollar strength and realignments in global trade could catalyse a renewed cycle of outperformance for this often-overlooked segment of fixed income.
“Today, the profound macroeconomic shifts reshaping global capital markets – including the changing role of the US and the US dollar in the geopolitical and economic world order – are prompting investors to re-examine their approach to the asset class, whether this stems from an impetus to re-evaluate the overall size of the allocation or the types of strategies used to provide exposure,” the consultancy stated in its newly released paper, Emerging market debt: Extracting potential amidst complexity.
The report comes as institutional investor sentiment towards EMD remains resolute. Despite net retail outflows across both hard and local currency EMD markets over the last three years, 80% of institutional investors surveyed by bfinance indicated they intend to maintain or increase their allocations over the next 18 months.
The research draws on data from the firm’s November 2024 Global Asset Owner Survey.
This continued commitment is underpinned by structural yield advantages and diversification benefits.
“EM debt offers a compelling yield relative to developed market bonds,” the report noted.
While perceived volatility and complexity have kept some investors on the sidelines, bfinance finds that blended strategies – those combining hard and local currency exposures from sovereign and corporate issuers – have shown particular promise.
Blended strategies delivered the highest median excess return (0.59% net of fees) and the most consistent outperformance over the past decade, with 77% of managers outperforming their benchmarks.
Currency considerations are also playing an increasing role in portfolio construction. The report highlights that the optimal balance between hard and local currency exposure varies significantly by base currency. For sterling-based investors, local currency allocations have historically improved both returns and volatility outcomes.
Implementation nuance remains critical, especially around benchmark selection and FX hedging.
The analysis reveals that for UK-based investors, a balanced approach can yield superior risk-adjusted returns compared with US dollar-based benchmarks. Nevertheless, hedging methodology varies widely across funds, with some approaches eroding potential benefits due to unnecessary exposure to US dollar volatility.
“Investors must give careful thought to implementation mechanics, which can materially shape investment outcomes,” the report stated. This includes considering home currency correlations, selecting appropriate benchmarks, and scrutinising fund-level hedging practices.
With growing dispersion in country-level returns and wide spreads relative to similarly rated developed market debt, bfinance believes the EMD universe offers fertile ground for alpha generation, particularly through active, bottom-up management.
Read the digital edition of IPE’s latest magazine
