By Paul DeNoon
One key attraction of emerging-market debt is that it can help investors to diversify existing portfolios of developed-market fixed-income securities. But there’s more than one kind of diversification, and more than one way to approach the opportunity, depending on each investor’s objectives.
There are two broad types of diversification. The first type, portfolio diversification, seeks to mitigate systemic, market-level (beta) risk. The second, issuer diversification, deals with issuer-specific (alpha) risk.
Mitigating Market-Level Risk
Portfolio diversification involves seeking strategies with low correlations to the existing assets in a portfolio. The table below shows the correlations between various categories of developed-market (DM) and emerging-market (EM) debt.
For example, the historical correlation between U.S. Treasuries and local-currency EM sovereign debt hedged into U.S. dollars is an attractively low +0.4. So for an investor looking to diversify a portfolio of U.S. Treasuries, this might have been a good solution. For both sectors, the primary source of risk and return is interest-rate exposure. The diversification derives from the fact that EM interest rates are influenced by a different set of factors. In recent years, EM local-currency debt has offered exposure to many countries that are not at the same point in their economic cycles as developed countries.
But the correlation number doesn’t tell the whole story. When weighing up the choices, investors should also ask themselves: “What’s the role of this allocation in the portfolio?”
For example, the U.S. Treasury investor above might notice that even lower correlations (between zero and +0.1) are available from two other choices: hard-currency high-yield EM sovereigns and local-currency unhedged sovereigns. And both would offer more yield, albeit with higher volatility.
However, one thing to note is that, in both cases, the diversification effect is not coming from exposure to EM interest-rate factors as much it is from exposure to credit and currency. The U.S. Treasury portfolio is driven primarily by U.S.-dollar interest-rate exposure. But both of the choices above would add something new to the mix. Hard-currency high-yield EM sovereigns would introduce subinvestment-grade securities into a portfolio of “low-risk” assets, while local-currency unhedged sovereigns would add currency exposure to a previously all-U.S.-dollar portfolio. Either of these could be a plus or a minus, depending on the investor’s specific objectives.
The bottom line is that, in order to make an informed decision, it’s important to understand the nature of the diversification opportunity in each EM sector and to explore how it’s likely to change the behavior of the existing portfolio.
Mitigating Issuer-Level Risk
Not all EMD opportunities provide much diversification at the portfolio level. For example, as the display shows, U.S. and EM high-yield corporate debt have a high historical correlation of +0.8, so adding EM high-yield to U.S. high-yield holdings wouldn’t result in much market-level diversification. But this high correlation could be attractive — for example, to credit investors who want a bigger opportunity set.
For investors like these, the main attraction of adding EMD is issuer diversification — in other words, protection against issuer-specific (idiosyncratic) risk. If that’s the case, they might be less concerned about correlations than they are about the number of names in the sector. EM corporates, for example, span almost 400 issuers from 43 countries (the JPMorgan CEMBI Broad). So for investors with portfolios of (for example) EM sovereigns or U.S. investment-grade corporates, adding EM corporates means more opportunities to add value through stock selection and diversify with a higher number of smaller position sizes.
When the goal is issuer diversification, investors should compare each EM sector with the DM sector that best matches their primary source of risk and return — interest rates, credit or currency — so as to ensure an apples-to-apples comparison.
One such comparison would be the two high-yield portfolios above, because they are both primarily driven by noninvestment-grade credit risk. Another comparison would be the initial example of the U.S. Treasuries and the local-currency U.S. dollar–hedged sovereigns, both of which are driven by U.S. interest rates.
For an overview of how we think about the different sources of risk and return in EMD, please see my last blog on the EMD tool kit. In my next blog, I’ll discuss some other considerations, including how the different EMD sectors fit onto the risk/return continuum.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio managers.