Emerging market debt has performed well over the long-term, but the asset class has struggled more recently.
Ellis (pictured), who manages the FF Emerging Market Debt fund, says that spreads of emerging market bonds have widened in recent months as the growth outlook for these economies has deteriorated. However, the manager says that the lack of value in developed fixed income markets and an expected pick-up in global economic activity will see an increase in demand for emerging market debt, and that spreads will tighten considerably over the medium-term as a result.
"The question I ask myself is how much can spreads tighten and what is the risk premium of investing in EM debt? There has obviously been a rally and real spread-compression over recent years," he said.
"The year 2007 was when spreads were at their tightest. Hard currency spreads were 150 basis points then and now they are 280 basis points, so there is still plenty of room for them to narrow."
"In terms of the quality of EM debt, in regard to rating agencies and other metrics such as fiscal balances, private and public sector debt and so on, there has been a continuous improvement relative to developed markets."
"Can spreads tighten from here? My answer is yes, from the point of view that the fundamentals in EM are so much more superior and have actually been improving compared to developed markets."
"Also, when you look at the rating agencies' actions since the onset of the financial crisis, you’ve seen a net upgrade in EM countries, and in developed markets you’ve seen a net 117 downgrades."
Due to the high level of interest towards emerging markets debt, Ellis expects spreads to tighten, which will in turn lead to strong capital appreciation.
"The structural trend for issuance in sovereign corporate debt is very positive, because there isn’t any," he continued.
"The other factor of course is when you look at what the Fed is doing with their QE programme; by buying $40bn a month of spread products through mortgage-backed securities, it is causing a dearth of spread products."
"People have increasingly had to look down the spread spectrum for yield and one of the recipients of that is the emerging markets – so the technical backdrop still looks good for EM debt."
Ellis took over the $1.7bn FF Emerging Market Debt fund in November 2012.
According to FE Analytics, the offshore fund has returned 104.34 per cent since launch in February 2006.
Performance of fund since Feb 2006
Source: FE Analytics
FF Emerging Market Debt has an ongoing charges figure (OCF) of 1.68 per cent and requires a minimum investment of $2,500. The fund has a yield of 3.78 per cent.
Ellis thinks untapped demand for emerging market debt is actually a positive for investors in the asset class, and could be a big driver of performance in future.
"When you look at the flows into EM debt, it is still a very positive trend for the asset class."
"I would say that the flows coming into EM debt – especially local currency – are by no means a flash in the pan phenomenon, where people just hunt for yield. This is a structural re-allocation of capital towards EM which has got a long way to go."
"The EM fixed income market accounts for around 15 per cent of the total global debt."
"There is a very limited issuance of EM spread products, in net terms the sovereign external debt market last year expanded by $10bn – a very, very small amount. There were huge inflows, but no new issuance to absorb them."
Ben Willis (pictured), head of research at Whitechurch, says he is a fan of EM debt and has seen increased interest in the asset class; however, he feels investors should understand that it’s not as low risk as other areas of the bond market. "EM debt polarises opinion quite a bit, especially with local currency debt as it can be very volatile and can be correlated with emerging market equities," he said.
"Spreads are historically quite low as it has become very popular with sovereign wealth funds looking to diversify away from the developed bond market."
"Western corporate bonds had a good year last year, but this year I think there will just be coupon returns."
"We are in the camp that thinks EM debt is still an attractive asset class, especially local currency EM debt as those countries' currencies are in good shape and you should get good capital appreciation from them."
"Hard currency is less volatile. If there is a lack of issuance compared to the demand, it will push prices up and therefore yields will come down, making them look unattractive to new investors."
"It may well be the case that if investors time it wrong they could really miss the boat," he added.