EMD: the missing piece of the cashflow matching puzzle

$15 trillion and rising – but not yielding. This is the current value of bonds around the world offering a negative yield as a result of central banks’ largesse.

This trend is most pronounced in sovereign bonds, but yields in developed markets’ investment-grade corporate debt have been depressed too. Around 40% of the euro-denominated investment-grade credit market now offers a negative yield.

This presents challenges for all investors, not least those pension schemes or insurance companies utilising cashflow-matching strategies to meet their liabilities. The problem is particularly acute at the front end of the cashflow-matching profile, where yields tend to be lower, especially when many investors do not consider sub-investment-grade assets to provide a certain enough cashflow profile to be considered in cashflow-matching strategies.

We believe that emerging-market investment-grade fixed income offers a solution to this cashflow-matching puzzle by significantly expanding the universe for meeting yield requirements and offering welcome diversification from traditional solutions that have typically focused on developed markets’ investment-grade corporate credit.

Myth busting

To make the case for EMD’s role it is helpful to cull two common misconceptions about the asset class. The first is that it is a niche market.

This notion could not be further from the truth. EMD is an asset class not just worth around $12 trillion today, but one that is growing. Cashflow-matching solutions are likely to focus on the hard-currency investment-grade portion of the emerging-market universe, which is approximately $2 trillion in size. For comparison, the UK’s investment-grade market is smaller than $1 trillion.

Another misapprehension investors have about emerging-market fixed income is that it is an exotic, risk-prone asset class. We believe this is a short-sighted assessment and one that usually stems from the notion that EMD is simply one homogenous group.

This myth is quickly dispelled when one realises that the EMD universe encompasses an extremely diverse spectrum of countries, ranging from AAA issuers all the way down to D. More than half of the bonds in the most closely followed EMD indices are investment grade.

Crucially, many of these emerging-market bonds offer higher yields than developed-market equivalents of the same credit quality. Qatar National Bank, for instance, is a substantially state-owned entity with a five-year A+ rated bond that trades at a premium of approximately 35 basis points compared with Daimler’s five-year A rated bond.

Similarly, Codelco is one of the world’s largest copper producers and is wholly owned by the Chilean state. Yet Codelco’s bond spread on its six-year A rated debt is around 50 basis points above Rio Tinto’s six-year A rated paper.

Keeping active

Given the higher spreads on offer, we believe that emerging-market investment-grade fixed income can drive a significant improvement in the risk-adjusted return potential of a cashflow-matching portfolio.

Due to the nuances of the EMD universe, taking a more active approach to the emerging-market allocation of a cashflow-matching strategy can be beneficial. This affords the investor more flexibility to mitigate credit risk while targeting better risk-adjusted returns. We would nevertheless expect the turnover of an EMD sleeve to be significantly lower than that of a pure active approach.

We regularly meet clients with cashflow shortfalls at the front end of their matching portfolio. We are generally able to construct a hard-currency investment-grade EMD portfolio with half the duration of the typical developed-market investment-grade credit portfolio, whilst achieving an extra 50 basis points in spread.

This enables schemes to match their cashflow liabilities more efficiently without dampening returns.

For more detail on these issues and information on how we construct portfolios in practice, you can find our full paper on this topic here.