‘The multi-factor nature of this asset class is precisely why it warrants a dedicated allocation,’ says William Blair’s Jason Stefanelli
Institutional investors are currently facing a dilemma. There’s too much risk concentrated in too few places while US equities have surged to secular highs and private credit markets feel frothy.
But the biggest concern for William Blair’s Jason Stefanelli is the state of Western government balance sheets. According to Stefanelli, debt burdens keep climbing, and unlike previous borrowing cycles that financed large-scale infrastructure or wartime needs, the recent surge lacks that productive foundation.
"A lot of that debt's been spent irresponsibly," said Stefanelli, business development manager at William Blair, citing the surge in developed-market sovereign borrowing since the pandemic. "Where in the past you've seen a lot of sovereign nations go into high debt, it was usually to fund things that weighed a lot. Like the big infrastructure booms, like the industrial revolution, you had wars that you funded. This round, it was like almost a consumption debt spend."
Against that backdrop, he argues that emerging markets debt (EMD) deserves a spot in portfolios. Not as a tactical side bet, but as a strategic allocation that fundamentally changes how a portfolio earns income, diversifies risk, and weathers stress.
He boils the case for EMD down to three pillars, noting that it offers strong risk-adjusted return potential for plan sponsors, it delivers geographical diversification and correlation benefits, and it sits on the right side of a widening gap between developed and emerging market fundamentals.
"Where DM markets are becoming much riskier, fundamentals in EM are improving," he said. “It represents a growth area to invest in as those economies become more mature and evolve over time.”
Historically, most Canadian plan sponsors have relied on core-plus or global fixed opportunistic mandates to cover their fixed income needs. But Stefanelli argues those mandates play a role but fall short of what a dedicated EMD allocation can deliver.
Over the past year, emerging markets have undergone a structural transformation, particularly as countries that were once considered fragile and dependent on the West are now self-funding and trading with each other at an accelerating pace, noted Stefanelli.
That maturity, he suggests, combined with double-digit yields still available in parts of the asset class, makes EMD a credible source of income at a time when US Treasuries - long considered the ultimate safe haven - face questions about their reliability given ballooning debt levels and political pressure on the Federal Reserve's independence.
Stefanelli identifies two investor profiles drawn to dedicated EMD allocations. The first is the legacy Canadian core-plus pension plan – typically a mid- or smaller-sized sponsor that has grown frustrated with generalist managers delivering unstable betas and inconsistent exposures.
Those plans are carving out specialist EMD mandates rather than relying on a single manager to cover everything. The second is the credit opportunist experiencing private debt fatigue.
"While we think private credit is an excellent asset class, we do feel that perhaps the returns aren't going to be there as they once were," he said, adding EMD offers those investors liquid access to global credit without the lock-up periods or the growing manager-selection risk that now shadows private markets.
He positions EMD as sitting between developed-market fixed income and global equities, serving three distinct functions. The first is income generation as EMD provides a structurally higher yield than domestic fixed income, supported by stronger nominal growth and risk premia, allowing pension plans chasing a long-term real return target to improve portfolio carry without taking on full equity risk.
The second is credit diversification as EM sovereigns and corporates expose a portfolio to macro cycles, fiscal regimes, and commodity sensitivities that move out of sync with US, Canadian, or European credit cycles.
Meanwhile, the third is its role as a hybrid bridge asset.
"Emerging markets debt exhibits hybrid behavior, meaning it's part rates, it's part credit, and it's part currency in its construction," Stefanelli said. "The multi-factor nature of this asset class is precisely why it warrants a dedicated allocation, rather than being embedded passively with global aggregate mandates," he said, emphasizing that for Canadian pensions specifically, it also addresses the structural concentration in North American credit and resource-linked domestic exposure.
The correlation data backs the diversification argument as EMD's historical correlation with equities has run between 0.5 and 0.6, climbing closer to 0.7 with credit markets in more recent periods, according to data from William Blair.
"Not only is it a diversifier to equities, it's also diversifier to other fixed income asset classes as well," Stefanelli said.
Moving further out, the spread spectrum does introduce more risk, but he argues investors are being compensated for it because EMD remains a dislocated, under-exploited asset class where alpha generation is still possible. Some managers also run an opportunistic sleeve within hard currency EMD that reaches into frontier markets for additional return, noted Stefanelli.
While he underscored that William Blair’s EMD strategies don’t currently invest in collateralized debt obligations (CDOs), he highlighted how these structures show up in the asset class.
In emerging markets, securitised vehicles that tranche credit risk are less prevalent than in developed structured credit markets, yet investors can still encounter them via EM corporates (through CLOs, for example), structured sovereign risk-transfer deals, and bank-originated securitisations.
He sees potential benefits in the form of higher yield if investors choose tranches carefully, some structural credit enhancement, and broader diversification across underlying collateral pools. Against that, he stressed the drawbacks, pointing to complexity, lack of transparency, liquidity that can vanish in stressed markets, and a heavy reliance on models.
From a practical portfolio-construction perspective, he believes Canadian pension allocators should treat structured EM exposure with caution. In his view, EM CLO or CDO positions, if used at all, belong only as a small satellite sleeve rather than any kind of core allocation.
"We don't recommend a dedicated frontier portfolio, but perhaps a blend of some frontier within an EMD portfolio, we think is a good way to approach the asset class," he said.
