18 December 2018
Despite a lot of negative headlines in the summer, emerging markets are still a strategically important asset class for insurers, Sanjay Yodh and Kevin Daly of Aberdeen Standard Investments tell Vincent Huck. But the asset class is tainted by prejudices.
At the middle of this year, emerging markets and in particular Turkey and Argentina were in a bit of a pickle, to put it mildly, triggering an extensive sell off of assets.
However, asset managers have defended the asset class, and vocally, for offering good risk-adjusted returns and for being an excellent means of diversification.
“The August selloff was larger than expected, as it was exacerbated by a sharp sell-off of the Turkish lira, adding to the gloom hanging over emerging markets,” Sanjay Yodh, director US insurance business development at Aberdeen Standard Investments (ASI), says.
This still hasn’t changed ASI’s view on emerging markets (EM), he says. “Valuations on hard currency, local rates and currencies are cheap on a fundamental basis, but [we] would recognize that headline risk on EM remains elevated.”
No insurer has taken risk off the table, according to Yodh, indeed he says EMs actually grew in interest to US insurers towards the end of last year.
“Late last year and early this year, as we ramped up our conversations with insurance companies in the US about how they were going to change the dynamics of their asset allocation going into 2018, there were a few common themes that came about and one was clearly increasing, or initiating, emerging market debt exposure,” he says.
When previously their asset allocation to EMs was 1% or less, Yodh says it could now easily reach 5%.
Kevin Daly, senior investment manager for emerging market debt at ASI, says US insurers are catching up with the trend set among European insurers, of proactively increasing their allocation to EMs in recent years.
One of the reasons why EMs are of interest to insurers is that they fit well with what the insurers already know, Yodh explains. “If you think of the underlying characteristics of EMD versus US investment-grade, high yield, or government debt, the process of doing the research, evaluation and risk management is the same. The only difference is having the familiarity with the individual companies, and individual nations that you're accessing the debt from.”
Sovereigns versus corporates
Asked about the best way to enter EMD through sovereign or corporate bonds, Yodh notes there are diverging interests on the part of US insurers.
While the larger ones, more seasoned to EMD exposure, are looking at corporate debt in the high yield universe, the second part of the insurance market only now starting its EMD journey is looking more at a ‘blended’ approach.
“From meetings we held with some US insurers, we saw a growing understanding of the benefits of EM corporates,” Daly says. “There is a perception that EM corporates are higher risk than EM sovereigns, but actually if you look at historic returns, you see a much lower drawdown and much lower volatility in EM corporates versus sovereigns. At the same time, if you look at average returns, it is very comparable to sovereigns.”
During the fall in commodity prices in 2017, there was a pretty sharp drawdown in US high yields, too, but not among EM corporates. Daly said that surprised many people who did not understand that EM corporates can generate attractive returns with lower volatility and lower drawdowns.
Building an understanding to EMD is the main obstacle that asset managers face when speaking with insurers.
“There are two attributes that many insurers aren’t totally aware of: the size of the market itself and how much it has grown, and the dynamics on the relative basis,” Yodh explains pointing at the down side protection relative to high yield and the diversification benefits.
Insurers that have not invested in EDM before usually perceive the asset class as higher volatility, and that the country risk factor is too high, Daly adds. “But when you compare BB-rated corporates, what you find is typically the US name will have higher leverage, and yet you are getting a much lower yield or spread on those bonds than you are in the EMs. The perceived higher country risk is another one of the [deterring] characteristics.”
Interest rates impact
Sitting at the end of the credit cycle, especially in the US, one might question whether a trend towards EMD is sustainable, or if we will we see insurers return to domestic investments.
Higher yielding bonds have performed fairly well in an environment of rising treasury yields, Daly acknowledges. However, he adds that investors are concerned or even nervous about the risk of a repricing normalisation in US interest rates, and the allocators might want to look rather at short-duration strategies, which are pretty ample in EM too.
“The benefits of EMD have historically paid off for investors, be they institutional or high net worth retail, so evidence is there for past performance, though of course this doesn't predict strong performance in the future,” he continues.
“But what it comes down to is the very valid argument of diversification. That is something that we have been pressing hard.”
Coming from a strategic standpoint, many of the insurers' chief investment officers are not looking to time the market, Yodh adds. “They are more concerned, over a long-term horizon, with strategic asset allocation, which should include some EMD.”
And if, because of rising rates, the CIOs might shorten the duration of their overall portfolio - to Kevin's point - they might look for a shorter duration-type strategy, but it would include EMD.”
The bottom line for both Daly and Yodh is that the volume of EMD corporate bonds alone is estimated to exceed $2trn, whereas the US high yield market is in the region of $1.5trn large. Therefore, they reason, insurers can’t afford to ignore the asset class any longer.
Yodh says: “The EMD [market] dwarfs the size of US corporate high yields, and it warrants paying more attention to, and making a strategic allocation [into] the asset class.”