The war in Ukraine has added continued volatility to emerging markets fixed income assets. According to a study published by Vontobel Asset Management, while institutional investors globally are wary of the war’s market and economic impacts, they remain optimistic for the months ahead.
Vontobel surveyed more than 300 institutional investors and discretionary wealth managers globally in North America, Europe and Asia-Pacific during the first quarter of 2022. According to the survey, 72 per cent of institutional investors across the globe were optimistic about GDP growth, inflation and bond yield premiums in European emerging markets prior to Russia’s invasion of Ukraine. However, among responses received after the invasion, only 55 per cent of institutional investors were optimistic.
Despite decreased optimism around European emerging markets, the broader emerging markets space is seen as appealing for institutions. More than half (64 per cent) of institutional investors report that they plan to increase (somewhat or substantially) their asset allocations to emerging markets fixed income over the next 24 months. This was particularly pronounced among UK institutions, with 72 per cent of UK investors planning to increase emerging market fixed income allocations over the next 24 months. Of these, 24 per cent of UK investors said they would make a substantial increase of more than 10 per cent.
This confidence in emerging market fixed income is also already reflected in the existing portfolios of UK institutions. Nearly twice (14 per cent) as many UK institutional investors currently hold between 10 – 20 per cent of their portfolio in EM fixed income compared with the global average of 8 per cent.
The top three reasons that institutional investors globally cite for increasing their allocations included: diversification benefit versus current holdings (56 per cent), highly liquid market (48 per cent) and favorable ESG prospects (47 per cent).
“Despite market headwinds, global institutional investors recognise the need to diversify to provide both higher yields and insulation from market and geopolitical volatility in other asset classes,” says Simon Lue-Fong, Head of the Fixed Income Boutique at Vontobel. “Emerging markets fixed income can meet those needs in investor portfolios but requires an experienced active manager to navigate the unique challenges associated.”
When investing in emerging markets fixed income, institutional investors globally indicated the top challenges their institutions face as: concern about default rates and debt load (51 per cent), liquidity (48 per cent), volatility (45 per cent) and concern about corporate governance, data quality and transparency, and reporting standards (38 per cent).
“These concerns are not new; the asset class is still treated as an exotic niche by many investors. However, for active investors that understand the asset class, it offers enormous opportunities—the impact of default rates is often exaggerated, and volatile periods offer excellent opportunities to exploit market inefficiency,” comments Lue-Fong.
Given the heightened importance of monitoring ESG factors in emerging markets, almost all (91 per cent) of institutional investors across the globe report using ESG investment strategies in their emerging markets fixed income allocation, including: impact investing (55 per cent), systematic screening to include or exclude securities (54 per cent) and engaging with issuer management to influence ESG policies and practices (49 per cent).
Despite the widespread adoption, institutional investors report several barriers that hold their institutions back from making ESG-focused investments in emerging markets fixed income: data inconsistency by third-party providers (62 per cent), skepticism about the positive impact of ESG investments (61 per cent), the perceived higher risk associated with emerging markets fixed income (43 per cent) and the lack of suitable ESG offerings from external asset managers (43 per cent).
“Within the last few years, ESG has become table stakes for institutional investors, and emerging markets fixed income investors are finding that the asset class presents a unique position to generate returns while making a positive impact,” says Lue-Fong.
“Our study found that institutional investors are more interested than ever in sustainable investment products and rely on the expertise of active managers to identify attractive and sustainable investment opportunities while managing the unique risks inherent in emerging markets.”
Additional UK-specific results revealed that 24 per cent of UK institutional investors said they expect to decrease allocations to DM fixed income in the next 24 months while only 3 per cent expect to decrease EM fixed income allocations.
In fact, 72 per cent of UK investors said they would increase EM fixed income allocations, with 24 per cent saying they would make a substantial increase of more than 10 per cent.
The reasons cited by UK institutional investors for allocating more to EM fixed income were the highly liquid market (81 per cent) and the diversification benefit (75 per cent).
However, it doesn’t come without its challenges. The biggest issue when investing in EM fixed income was concern about corporate governance, data quality and transparency, and reporting standards, as cited by 52 per cent of UK respondents