Many institutional investors have gradually internalized mandates once awarded to external managers, seeking tighter cost control, greater transparency, and improved alignment. Emerging market debt (EMD), however, has often remained outsourced. The breadth of the opportunity set, wide cross-country dispersion, and the need for on-the-ground expertise have made it operationally and analytically demanding to replicate in-house.

Danish pension fund PensionDanmark, on the other hand, has methodically built internal capabilities in emerging market fixed income. Today, a substantial share of both hard currency and local currency sovereign exposure is managed in-house, with only a limited number of specialized managers retained to complement the internal platform.

When Klaus Sølund, Senior Portfolio Manager in Emerging Market Debt, joined PensionDanmark in 2013, the majority of the allocation was externally managed. The internal build-out began cautiously. “One of the main ideas was to start with a smaller in-house product to better understand the asset class,” Sølund recalls. As internal expertise strengthened, more assets were transitioned from external mandates to internal management.

“One of the main ideas was to start with a smaller in-house product to better understand the asset class. We realized we could use our balance sheet efficiently, lower costs, and retain a similar level of alpha with less risk.”

Today, with two dedicated portfolio managers, that deeper expertise allows the team to assess more precisely where external mandates add value. “The idea was to be able to select external managers with a much better understanding of niche segments, because we were investing in the broader asset class ourselves,” he explains. At the same time, managing assets internally proved economically compelling. “We realized we could use our balance sheet efficiently, lower costs, and retain a similar level of alpha with less risk,” says Sølund.

Structural Premiums and Long-Term Capital

Within PensionDanmark’s broader credit allocation, emerging market debt occupies a clearly defined role. Sølund views the asset class as structurally less efficient than developed market credit, creating opportunities to capture persistent risk premia. “We don’t see these markets as fully efficient. That creates scope for higher returns while also contributing to diversification,” he says.

“We don’t see these markets as fully efficient. That creates scope for higher returns while also contributing to diversification.”

A meaningful part of this premium is linked to structural illiquidity. Emerging market bonds, particularly during periods of market stress, often experience sharper drawdowns than segments such as developed market high yield, and recoveries can be more protracted. For investors with long-term capital and limited liquidity constraints, however, this dynamic can be advantageous.

“As a pension fund, we have a balance sheet that can tolerate illiquidity. We can hold smaller, less liquid positions and remain invested through volatility,” Sølund notes. Rather than attempting to time short-term dislocations, the team focuses on harvesting carry from assets where they believe compensation for risk is structurally attractive.

Strategic Allocation with Tactical Delegation

PensionDanmark’s exposure to emerging market debt is anchored in strategic asset allocation. The weight reflects expected return, risk characteristics, and diversification benefits relative to the broader portfolio. Tactical adjustments are primarily delegated to individual mandates rather than driven at the top level. “It’s mostly a long-term allocation,” he says. “Then we allow the individual mandates to express the tactical view within their respective segments.”

“It’s mostly a long-term allocation. Then we allow the individual mandates to express the tactical view within their respective segments.”

The current allocation is broadly in line with a strategic emerging market fixed income benchmark: approximately 50 percent in hard currency sovereign debt, 30 percent in local currency sovereign debt, and 20 percent in corporate debt across emerging and frontier markets. “We’ve had that structure for a long time. I wouldn’t call it completely static, but viewed over time it has been relatively stable,” says Sølund. That stability reflects the way PensionDanmark seeks to extract value from the asset class. Rather than rotating aggressively between sub-segments, the team focuses on harvesting structural premiums within each sleeve.

“We try to build robust portfolios that can exploit liquidity premia and inefficiencies in the market,” Sølund explains. “The ambition is to deliver stable excess returns year after year without making large shifts within the asset class. At the same time, when rare and outsized dislocations occur, we are prepared to take on additional market risk to capture those opportunities.”

Core and Satellite Implementation

Implementation follows a clear core-satellite framework. The internally managed core provides broad beta exposure to the asset class, both in hard currency and local currency sovereigns. Around this, PensionDanmark allocates to external managers with differentiated, niche strategies. “The core is where you get the running return of the asset class,” Sølund explains. “Then we try to generate a bit of extra return on top. The satellites are more niche-oriented managers that do something different.”

“The core is where you get the running return of the asset class. Then we try to generate a bit of extra return on top. The satellites are more niche-oriented managers that do something different.”

For the externally managed portion of the allocation, PensionDanmark seeks flexible, opportunistic managers with clearly differentiated approaches. These mandates are intended to complement the internally managed core by accessing segments or strategies that require specialized expertise. “It’s difficult to define a formula for a niche manager that truly does something different,” says Sølund. “By definition, not everyone can replicate it, otherwise it wouldn’t be niche.”

In evaluating managers, the team prioritizes stability, a demonstrable track record, and a clear competitive edge. “We look carefully at past performance, but also at whether returns are driven by genuine skill and a repeatable process or simply by taking more risk,” he explains. Satellite managers typically receive smaller mandates than the internally managed core. However, they are granted greater flexibility and higher tracking error, reflecting the expectation of higher excess returns over time.

Hard Currency vs. Local Currency Dynamics

While hard currency emerging market debt is primarily a credit instrument, exposing investors mainly to sovereign or corporate credit risk, local currency debt introduces an additional layer of currency and domestic macroeconomic risk. “A large part of the risk in local markets comes from the currency component. It accounts for roughly two-thirds of the volatility in that segment,” says Sølund. 

As a result, portfolio construction in local currency debt requires a different emphasis. As a result, the local currency portfolio is constructed with particular attention to diversification across macro drivers, seeking return sources that are less correlated with pure FX movements. “The aim is to generate additional return without proportionally increasing overall risk.”  

Within hard currency debt, Sølund extends the opportunity set beyond mainstream emerging markets into frontier economies. “The universe is broader on the hard currency side, and it includes more frontier countries. Naturally, that’s where we spend more time.”

ESG as a Catalyst for Internalization

ESG considerations were one of the initial catalysts for bringing EMD management in-house. Direct management allows closer oversight of sovereign and corporate exposures, enabling more nuanced engagement with ESG risks at the country and issuer level. “Because we manage the investments ourselves, we are much closer to the ESG decisions,” Sølund explains.

“Because we manage the investments ourselves, we are much closer to the ESG decisions.”

Over time, this proximity has strengthened the investment process more broadly, reinforcing the case for internal management beyond cost savings. “We’ve become closer to both the market dynamics and the ESG implications,” he says. “The initiative originally had a strong ESG motivation, but it also evolved into a driver of alpha generation and lower costs. That wasn’t the primary objective at the outset, but it has clearly become part of the result.”

Outlook: Strong Past Returns, More Moderate Expectations

Emerging market debt has delivered robust returns over the past three years. “Returns have been very strong, and we’ve been pleased with the outcome,” Sølund says. However, he cautions against extrapolating those outcomes. “We don’t expect the next three years to look the same,” he notes.

From a macro perspective, the backdrop for emerging markets has improved compared to a few years ago. “Fundamentals are stronger than they were previously, and the U.S. dollar is not as strong as it was, which generally creates a more supportive environment for EM,” Sølund explains. “However, credit spreads are tight across markets, including hard currency emerging market credit,” he says. “That limits the scope for outsized returns from here.”

“However, credit spreads are tight across markets, including hard currency emerging market credit. That limits the scope for outsized returns from here.”

Local currency debt, however, presents a somewhat different picture. “Local markets stand out slightly at the moment,” Sølund adds, pointing to relative spread dynamics and differentiated risk drivers within that segment.