The most recent Global Asset Owner Survey by bfinance reveals that due to a compelling yield relative to developed market bonds - with around 60% now rated investment grade - a growing number of institutional investors plan to maintain or increase their exposure to Emerging Market Debt (EMD) allocations over the next 18 months.
This data reflects the tilt away from traditional capital markets like London, Washington and Paris to new-world economies like Sao Paulo, New Delhi and Beijing.
While 50% of EM Hard Currency Sovereign Debt issuers - spanning over 80 countries – are now rated ‘investment grade’ - the local Currency EM Debt market, focused on larger emerging economies, now boasts investment grade exposure of around 80% - boosted by the inclusion of China and India in major indices in 2020 and 2024, respectively.
After analysing over a decade of manager performance, allocation trends, and implementation practices, the bfinance report, Emerging Market Debt: Extracting Potential Amidst Complexity, finds that while volatility and complexity have historically deterred some investors, the [EM Debt] asset class continues to offer material advantages for sophisticated institutions.
While these characteristics are particularly attractive to investors required to comply with risk-based capital rules, like insurance companies, the London-based investment consultancy believes they should especially resonate with investors with longer investment horizons and home currencies that align with EM exposures.
Why Aussie investors are better positioned to benefit
As a result, Frithjof van Zyp, Senior Director, Client Consulting at bfinance in Australia argues that fresh data highlights stronger risk-adjusted outcomes for A$-based investors—particularly in Local Currency strategies—and consistent alpha - that beats the market - from active management.
Based on these dynamics, van Zyp claims that Australian investors are in a structurally better position to benefit from Emerging Market Debt than many of their global peers.
“Our research shows that A$-based investors have historically seen stronger returns and lower volatility from Local Currency EMD, particularly when exposures are implemented thoughtfully,” said van Zyp.
In light of these findings, he urges Australian institutional investors to take a closer look at returns through the lens of other base currencies.
“Blended EMD strategies provide the broadest opportunity set and are particularly well suited to long-term institutional mandates in Australia,” van Zyp added.
“However, a nuanced approach to manager selection and benchmark design is essential… the most effective strategies are those tailored to an investor’s specific currency base and portfolio objectives.”
bfinance’s argument in a nutshell
While EM Debt returns are typically reported in U.S. dollars, van Zyp reminds investors that this U.S. dollar centric lens can obscure the realities faced by non-U.S. dollar investors.
In practice, the optimal balance between hard currency (HC) and local currency (LC) exposures in an EMD strategy can, adds van Zyp, vary significantly depending on an investor’s home currency and its correlation with EM currencies.
Over the past decade, the strength of the U.S. dollar has been a dominant macroeconomic theme, and this prolonged appreciation exerted a significant drag on the performance of unhedged LC EM Debt for dollar-based investors.
However, a closer look at returns through the lens of other base currencies reveals a largely untold story.
What’s all too often overlooked, bfinance data reveals is that Australian investors, whose home currency exhibited greater correlation with commodity linked EM currencies, experienced a much smoother ride.
“These investors saw from LC EM Debt roughly a third less volatility and more than triple the annualised return of their USD-based peers,” the report notes.
“Similarly, Canadian and euro-based investors benefited from both lower volatility (by approximately 25%) and more than double the return.”
Understandably, these differences in risk-return outcomes translate into different strategic allocations.
For U.S. dollar-based investors, the optimal approach would have been to maintain 100% allocation to HC.
While in contrast, Australian investors would have achieved the highest Sharpe ratio - a metric used to assess how well an investment performs relative to its risk - with a 100% LC allocation.
“This analysis underscores a vital point: the strategic design of Blended EM Debt mandates should reflect the investor’s home currency and its relationship to EM currencies,” the report concludes.
Key findings for Australian institutional investors include:
- Stronger outcomes for A$-based investors: Over a 15-year period, A$-based portfolios achieved triple the return and significantly lower volatility from Local Currency EMD than USD-based peers, due to favourable currency correlations and reduced drawdowns.
- Blended strategies consistently outperform: 77% of Blended EMD managers out-performed their benchmarks over the past decade, with these strategies delivering the highest median alpha (0.59% p.a. net of fees) and the greatest consistency across market conditions.
- Alpha driven by active use of credit, currency, and country levers: Managers who actively adjusted hard vs local currency exposure, tilted toward higher-yielding credits, or applied country-level research consistently added value, particularly in risk-on environments.
- Implementation decisions materially shape outcomes: The report stresses the importance of aligning benchmarks, mandate structures, and currency hedging with an investor’s base currency. For A$-based institutions, off-the-shelf U.S. dollar-centric strategies may obscure potential returns or introduce avoidable risk.
- Enduring institutional interest: While retail investors have reduced EMD exposure in recent years, institutional allocations remain resilient, with 80% of asset owners planning to maintain or increase exposure.
