By Jordan Harwood and Zhanying Li – “Emerging Markets Debt (EMD) continues to be a key component within many institutional fixed income portfolios today. Firstly, there is strong potential for capital growth and diversification, against the backdrop of developed market rates; and secondly, the asset class still provides essential income to those combatting cash-flow negativity amid the Covid-prolonged low yield environment,” says Jordan Harwood, Vice President, iShares UK Asset Owner Specialist.
By Jordan Harwood and Zhanying Li – “Emerging Markets Debt (EMD) continues to be a key component within many institutional fixed income portfolios today. Firstly, there is strong potential for capital growth and diversification, particularly against the backdrop of developed market rates. Secondly, the asset class still provides essential income to those combatting cash-flow negativity amid the (Covid-prolonged) low yield environment,” says Jordan Harwood, Vice President, iShares UK Asset Owner Specialist (photographed above).
He quotes Mercer’s latest European asset allocation insights from 2021, which found that 80 per cent of UK defined benefit pension schemes are now cash flow negative, with this figure expected to reach nearly 100 per cent within the next ten years .
Meanwhile, their 2020 European asset allocation survey also showed a 10 per cent increase in the number of institutional investors using EMD across the region. Outside of high yield bonds, EMD saw the largest reported increase of any growth-oriented fixed income segment .
Similarly, the BlackRock Global Insurance Survey in 2021 reported that 52 per cent of insurers were planning to increase EMD allocations in the next 12-24 months, the largest planned uptake across all fixed income exposures .
Harwood also notes that ETF flows at BlackRock are picking up the trend, with EMD contributing close to two-thirds of the iShares UCITS fixed income ETF flows year to date. Like last year, a large portion of this has been allocated to China bonds specifically once again as a new source of yield and diversification .
Clients are increasingly blending traditional vehicles, like mutual funds, with ETFs when accessing markets like EMD. Harwood says: “ETFs have their own secondary market liquidity and a bid to ask spread, which can be significantly tighter than the cost of trading the underlying basket of bonds, or equivalent (non-ETF) index mutual funds. The general rule of thumb is, the larger the ETF is, the more it is traded on the exchange, and the lower the trading cost.”
Harwood cites 50-55 basis points to be the typical spread level associated with trading the underlying basket for USD EMD bonds. Over the last 12 months, the most liquid EMD ETFs have traded on average nearly USD500 million each day, with trading spreads as tight as one basis point, under normal market conditions .
This has empowered institutional investors to move large blocks of EMD risk more comfortably, rebalance back to strategic weights more efficiently, and use tactical overlays more regularly.
He comments that the first half of 2020 marked a real turning point for institutional usage, having been the biggest test to date for Fixed Income ETFs. Many observers were expecting ETF trading to come to a halt, or worse, exacerbate the existing liquidity challenges. Like most periods of stress, they provide a source of real-time price discovery and an avenue for execution when liquidity in the underlying market deteriorates. This allowed investors to navigate extreme price dislocations, in spread markets like EMD, across a legacy marketplace that remains comparatively difficult to access. Globally, BlackRock counted over 60 first time institutional buyers of iShares Fixed Income ETFs in the first half of 2020 alone .
To help put this into context, “we [BlackRock] saw ETF trading surge to USD1.3 trillion in the first quarter of 2020, nearly half the total industry volume for all of 2019. Back in Europe, from late February to the end of March, we saw our own UCITS ETFs trading more than twice their average 2019 levels .
ETFs are not only reserved for those seeking new liquidity management or tactical asset allocation tools. The vehicle offers investors more granular exposures within broader markets. This is no different for EMD, which encompasses more than just hard and local currency but also pockets, like corporates, investment grade, high yield, and specific countries, like China.
The growing emphasis on ESG and sustainable investing has transcended all asset classes in recent years. “Some ETF providers now offer products with ESG tilts to some of the traditional parent benchmarks. Incorporation of ESG can help investors avoid allocations to controversial industries, including tobacco, weapons, and thermal coal, potentially improving the sustainability profile by nearly 20 per cent over a standard index” .
Not all ETFs are born (or managed) equally. “You have to find an index provider like FTSE Russell, that can launch new investable benchmarks in a scaled and timely manner. Then you must walk the walk and manage the resulting ETF product efficiently, especially in the context of EMD, where having global scale and choosing the right replication methodology can really add value back to investors,” Harwood says.
In terms of China, FTSE Russell has become the third, and possibly most important, index provider to admit Chinese government bonds into its flagship FTSE World Government Bond Index (WGBI). Commenting on the decision to include Chinese government bonds in the WGBI, Zhanying Li, Senior Director, Head of Data & Analytics Product Sales, APAC, FTSE Russell says: “The decision to add the second-largest bond market in the world to our flagship FTSE WGBI reflects the enhanced accessibility of the Chinese bond market with continued opening up reforms as well as rapidly growing interest from foreign investors to participate in the market.”
“FTSE published its fixed income country classification framework to manage the inclusion and exit of local currency bond market into the FTSE global or regional indices. For WGBI inclusion, a market needs to meet the 17 criteria specified in the framework. As of March 2021, China was considered to have met the criteria of WGBI inclusion. We have been working with the Chinese authorities to enhance its accessibility level to meet the criteria, including but not limited to: the simplification of the account opening process; the option to transact foreign exchange with third parties; and the freedom to lengthen the settlement cycle beyond T+3,” says Li.
China is one of the fastest growing spaces alongside EMD, especially from an ETF standpoint. In 2020, China Bonds saw USD6 billion in asset flows across all exchange-traded products, a number which was beaten in the first half of 2021 alone .
“Much of this has come from the institutional side, particularly UK schemes seeking new sources of yield and diversification as they continue to de-risk from equities,” Harwood says. ETFs, again, offer cost-efficient ease of access to Chinese onshore bonds, which can be operationally more complex to navigate relative to other public debt markets.
Bond markets have evolved significantly since the Global Financial Crisis in 2008, with the introduction of new index wrappers, new exposures, and marked improvements in the trading ecosystem. The traditional role of fixed income indexing in portfolios continues to be challenged and investors need not fear the change but instead embrace it. Institutional investors are increasingly realising the benefits of adding ETFs to their implementation toolkit, revolutionising the way clients invest in markets like EMD.
To contact the BlackRock team, please email firstname.lastname@example.org
For more information about the inclusion of China Bonds into FTSE WGBI, please download FTSE Russell research, WGBI Inclusion Confirms China’s Arrival on the Global Bond Stage.
 Mercer Investments: European Asset Allocation Insights 2021
 Mercer Investments: European Asset Allocation Survey 2020
 BlackRock, Global insurance Report 2021
 BlackRock, iShares Global Business Intelligence (as of October 2021)
 BlackRock, Bloomberg (as of October 2021)
 BlackRock, Turning Point Fixed Income ETF White Paper, July 2020
 Bloomberg (as of 20 March 2020). USD17.5 billion on average uses period from 21 February – 20 March 2020
 As measured by the improvement in JESG Score for the index tracked by EMES over the non-ESG benchmark. Source: BlackRock, as of 31 July 2021
 Bloomberg (as of October 2021)