Paolo Batori, global head of EM fixed income strategy at Morgan Stanley, foresees a fundamental shift in market dynamics. He said about 5 percent, or $80 billion, invested by insurance companies and pension funds in European government bonds would be switched into EM fixed income. Such an increase would roughly double the current exposure of such companies to emerging markets.
Mr. Batori uses the experience of Japanese life insurance companies after Japanese government bond yields declined in the aftermath of the financial crisis to reinforce his forecast. From the first quarter of 2009 to the third quarter of last year, Japanese life insurance companies increased their investments in foreign assets from just over 15 trillion yen to nearly 35 trillion yen as their search for yield intensified.
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But where in EM should yield refugees from Europe go? In one sense, there is plenty of potential; emerging market countries account for around 40 percent of global GDP but only 14 percent of the global government bond market by value. And differences in yield are stark.
"In aggregate, (local currency emerging market debt) yields 6.5 percent — just above the average for the last five years, and a full 1.25 percentage points above the level preceding the May 2013 taper tantrum," said Denise Prime, an investment manager at GAM.
"With former safe havens looking so unappealing, local-currency emerging market debt is an attractive option for fixed-income investors," she added.
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But, of course, yields such as these do not come without risk. One of the biggest concerns is that when the U.S. Federal Reserve tightens its monetary policy — though the timing for this is uncertain — funds could exit EM assets in favor of enhanced returns in the U.S.
The most vulnerable EM countries in such a scenario would be those that run hefty current account deficits and are therefore reliant on external financing. Such risks have been so well telegraphed that fund managers generally pursue a highly selective approach to EM assets.
One of the strategies deployed by investors to mitigate the risks of a strong dollar is to fund investments not by borrowing U.S. dollars but euro, which has depreciated or stayed steady against many EM currencies. In 2014, local EM currency bonds returned an average 7 percent against the euro and have returned 7.3 percent this year so far, according to Ms. Prime.
Another scheme to defray EM risk is to select the bonds of investment-grade issuers only, thus qualifying for inflows from insurance companies and pension funds that are restricted by their covenants from investing in issues designated as 'junk.'
In a separate category, a large but relatively untapped opportunity lies in China. Some $1.5 trillion of the $4 trillion global market for EM local currency bonds is located within China's domestic market, accessible to foreign investors only through a tightly controlled quota system.
But for those investors able to access allocations, the returns can be attractive because of the higher interest rate environment in mainland China. The China Universal Enhanced Bond Fund, for example, returned 13.12 percent in 2014, according to China Universal, a Chinese asset manager.
"We are definitely seeing increasing interest from European investors, both retail and institutional, who are hunting for yield in a world that is not really delivering their return targets," said Christopher Gunns, a managing director at China Universal.
But, he notes that Chinese domestic debt stretches the comfort zone for some European investors. "Among the institutional investors there are two things at play; a conservative risk budget competing with a need to generate returns."