There is no great secret as to why bond investors allocate to emerging markets. Diversification is part of the story, but only a part. The over-riding rationale is to obtain extra yield versus both developed market sovereign and corporate debt, which are yielding little in real terms.
Allocating to emerging markets became a “no-brainer” in the first decade of this century, as the post-Asian crisis recovery became a roaring bull market, with strong investment inflows driven by the commodities boom, low debt-to-GDP and strong GDP growth.
A simple beta approach to emerging market debt was sufficient to significantly outperform developed market bonds, and with similar levels of risk.
Even the financial crisis of 2008-09 failed to undermine emerging market strength. After an initial wobble in emerging market assets, it was clear that not only were emerging market fundamentals stronger than developed markets, but that quantitative easing (QE) would underpin this strength.
So there was little need to differentiate between countries and companies - almost all benefited from the desire of yield-hungry investors to buy emerging market debt. But, from May 2014, amid worries over China, the oil price and the Federal Reserve’s rate-raising policies, the asset class soured. Outflows in 2015 and early 2016 were substantial as emerging bond prices tumbled.
Investors with high exposure to emerging bond beta realised they would need more robust portfolios that still delivered higher yields than developed market debt, but with less volatility and less drawdown.
A range of emerging market debt strategies are designed with this aim. Let’s take a close look at three strategies which take different approaches to adding yield to fixed income portfolios: Natixis Asset Management’s fundamental and value strategy, Loomis Sayles’ short-dated emerging debt strategy and H2O Asset Management’s active relative value trades strategy.
Fundamental and flexible hard currency driven strategy
This strategy, managed by Natixis Asset Management (NAM), is designed to outperform the JP Morgan EMBI Global Diversified Index, one of the most representative benchmarks of the asset class. This index tracks sovereign and quasi sovereign emerging bonds denominated in US dollars. “Given its deepness and high heterogeneity (65 countries from BRICS to new frontier), this index has historically offered high risk-adjusted returns”, says Brigitte Le Bris, Head of Global Fixed Income and Currency at NAM. Over the last 14 years, the Sharpe ratio of the JP Morgan EMBI Global Diversified Index has compared favourably to the Sharpe ratio of the local debt index (JP Morgan GBI EM Global Diversified). The strategy has no duration constraint, may invest significantly beyond its benchmark investment universe in corporate bonds and emerging local debt. It also benefits from an active independent FX overlay.
The investment process combines a top-down and bottom-up approach. The investment team first establishes their views on the emerging debt asset class. Then they undertake a combined macroeconomic and valuation analysis country by country before selecting for each country the most attractive sovereign, corporate and/or local debt.
The relatively higher duration of the strategy should not be viewed as a hurdle for investors fearing higher US rates for three reasons. Firstly, the large credit spread offers a supportive carry able to compensate for interest rate moves. Secondly, this spread should narrow in a growth environment. Finally the duration of the strategy is managed actively.
Brigitte Le Bris and her team have a longstanding experience in financial markets, more specifically in currency, global bonds and emerging debt markets. Natixis Asset management manages a total of $2.5 bn1 of emerging bonds with different approaches: flexible hard currency, blended (hard and local), and total return.
Short-dated emerging market debt
We are increasingly seeing the value of short-dated emerging debt as an attractive, and potentially low-volatility, substitute for developed market bond strategies impacted by quantitative easing and negative short-term interest rates. By investing in shorter-maturity issues, which are generally less sensitive to changes in interest rates than longer-duration issues, investors of the Loomis Sayles Short Term Emerging Markets Bond strategy can mitigate the risks associated with any future rise in rates.
The strategy is particularly interesting for insurers, challenged by all-time low interest rates. Insurers need considerable amounts of shorter-dated bonds to facilitate their cash payouts. The situation is even trickier for European insurers which, under Solvency II, face high capital charges for longer-dated bonds held to enhance yields. By allocating to short-dated emerging debt, insurers can combine the extra yield offered by emerging debt compared to developed debt, with potentially lower volatility and a reduced capital charge.
“Short-duration capital preservation strategies represent the largest pool of money in the world, the bedrock of most portfolios,” says Elisabeth Colleran, Portfolio Manager at Loomis, Sayles & Company. She continues “With duration of 2.5 years, we could yield between 3 and 5% from a pool of emerging corporate bonds issued in dollars with an average rating at investment grade.”
Colleran notes that emerging market bonds offer substantial yield advantage relative to statistical default risks. “For the last fifteen years, emerging market bonds have outperformed equivalent rated corporate bonds from the U.S. with lower default rates.”
Although turnover in the strategy is low, it is important to continuously monitor the issuers to ensure they offer value. So the Loomis approach has a bottom-up bias, benefiting from the firm’s extensive macroeconomic and issuer research, including coverage of more than 60 emerging countries and 290 emerging-market corporate credits. Issuer selection is informed by Loomis Sayles’s credit rating system which was established more than 80 years ago.
Loomis Sayles believes corporate emerging market bonds are underpriced, thanks to the structural risk premium placed on them by many investors. Loomis’s strategy emphasises corporate debt, but may invest 5% or more in newer sovereign issuers, such as Sri Lanka, Bangladesh and Ghana, which are only just establishing themselves in the bond markets and are among the few sovereigns to issue short-dated securities in dollars.
Instead of allocating to bonds in a handful of developed markets, the strategy is highly-diversified among emerging debt markets. By allocating to so many emerging markets and issuers, investors minimise interest rate duration risk, spread risk and credit risk.
The fact that the blended average rating is above investment grade is particularly attractive for insurers. Colleran believes that by excluding bonds rated CCC or lower, the strategy is well suited to match the needs of insurers operating under Solvency II.
Macro muscle and currency arbitrage
There are other ways to seek long-term outperformance from emerging market bonds. H2O Asset Management takes strong directional views with the aim of reducing drawdown or enhancing returns when market trends are strong. Its success depends in no small part on strong macro capabilities. “We certainly have a tighter focus on macro than is common in the industry,” says Thomas Delabre, emerging markets portfolio manager at H2O. Delabre sees emerging market debt as a proxy for the health of the world economy. When global indicators are positive, the strategy invests in higher yielding assets with a longer maturity, and vice versa. He allocates principally to sovereign debt, but the macro approach also presents a number of opportunities in the corporates. “To successfully invest in emerging markets requires a sound understanding of global themes, not just emerging market metrics,” he says.
Thomas Delabre combines this understanding of macro themes with a relative value approach and currency arbitrage. H2O’s strategy can vary its duration depending on market conditions and carry out tactical arbitrage between hard and local currency bonds. It also favours relative value trades, which can make money even when markets are volatile and the direction uncertain. “We look at each country on its own merits and make relative value trades, pairing a company with increasingly strong fundamentals against a weaker one,” says Delabre.
The focus on individual countries rather than regions allows H2O to exploit currency movements too. Its currency overlay is designed to add alpha by overweighting currencies it believes are underpinned by strong and developing fundamentals. This added value aspect of H2O’s strategy – also known as “portable alpha” – differentiates it from many emerging market debt strategies and is designed to help outperform the benchmark. Its benchmark is a composite of 50% JPMorgan GBI-EM Global Diversified (unhedged) and 50% JPMorgan EMBI Global Diversified. Although the strategy aims also to reduce drawdown, it is benchmark-aware and is designed to be able to outperform the benchmark.
1 Source :Natixis Asset Management, 30 June 2016
Written on 19 October 2016