Emerging market debt: Outsized opportunities

After a year that prompted many investors to offload risk, BMO Global Asset Management assert the case for staying the course in this strategic asset class
February 2021

Valentina Chen

Co Head of Emerging Market Debt and Portfolio Manager

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Risk warnings

The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Investing in emerging markets is generally considered to involve more risk than developed markets.

The income and capital due from bonds is dependent upon the issuing country and/or company’s ability to pay and any default will adversely affect the value of your investment.

Changes in interest rates can affect the value of fixed interest holdings and may adversely affect the value of your investment.

Changes in rates of exchange may also reduce the value of your investment.

After a year that prompted many investors to offload risk, Valentina Chen, co-head of Emerging Market (EM) Debt at BMO Global Asset Management, asserts the case for staying the course in this strategic asset class – and offers an inside look at her team’s strategy and the region’s hot spots for the year ahead.

Even amid the lingering uncertainty, we believe emerging market (EM) debt must remain a core, strategic component of the portfolio for institutional investors. From higher yields to enhanced diversification, the asset class offers several benefits. Importantly, for EM hard currency sovereign bonds, the structural risk premium is approximately 370 basis points on average per year over the last two decades, with a realized default-related loss of approximately 50 bps per year.1 Investors in this subset of EM debt are therefore extremely well compensated for the risk they incur. The actual loss is significantly smaller than the risk perceived. As a result of this ongoing misperception, the structural premium can be harvested year-after-year for outsized cumulative returns.

It’s vital for institutions to understand the need to persist and reap the potential reward rather than jump in and out of the asset class because of potential left tail events (when the investment value moves beyond three standard deviations to the downside). Typically, a period of negative performance is followed by a sharp market rally, which was all too evident in the latter half of 2020. By staying the course, asset owners and managers should be able to capture the risk premium long term – instead of potentially ill-timing the market. In other words, time in the market is much more important than timing the market.

EM debt, particularly amid the current global extremely low to negative yield environment, also represents a unique opportunity to diversify and achieve attractive yields. Within the developed world, the analysis is practically limited to the U.S. and a few other developed regions, while the EM universe consists of approximately 80 countries, allowing for a host of diversification-driven, differentiated opportunities for an active manager. Furthermore, based on JP Morgan’s EMBIG Diversified index, EM investment grade debt is offering a yield of almost 3% and the high yield component is offering a yield of more than 7%, with the overall index offering a yield of around 5%. Investors simply cannot afford to ignore this asset class given the current yield-scarce backdrop.

By staying the course, asset owners and managers should be able to capture the risk premium long term – instead of potentially ill-timing the market.

A rich country-focus for strong return potential

In an effort to maximize the alpha potential, our sovereign-focused EM Bond Strategy at BMO Global Asset Management is based on country exploration. Our repeatable and well-established investment process anchors rigorous, in-depth research at the country level, combined with disciplined portfolio construction. Ideally positioned for deep-dive regional and country research, we’re differentiated by our team’s insight, expertise and authenticity. Of the ten members, seven of them hail from EM themselves – including Asia, Eastern Europe, Africa and Latin America, levering a longstanding local network of institutional contacts for access to on-the-ground information. Diversity also extends to our areas of specialities, with dedicated analysts for sovereign, quasi-sovereign and corporates, and local currency bonds working together to make tactical portfolio decisions.

Rather than using a typical Western framework in our macroeconomic fundamental assessments, we take more EM country-specific factors into consideration, and analyze economic indicators, vulnerabilities, flows trends, central bank and treasury activities accordingly. Our “country skillset” is completely aligned with alpha opportunity, which is more than evident in the strategy’s performance attribution (see below). It proves that understanding country fundamentals has been key to delivering consistent outperformance in emerging market fixed income – in every economic climate.

Our country selection has delivered strong returns over multiple investment cycles.

Time Periods Alpha from countries

2020

2.71

2019

0.94

2018

0.29

2017

0.41

2016

0.51

2015

0.07

2014

0.19

2013

1.40

Source: BMO Global Asset Management. StateStreet. Figures are performance attribution. As at 31.12.2020.

Past performance should not be seen as an indication of future performance.

Importantly, anchoring to the country level has offered strong downside protection for institutions. When comparing EM sovereigns, particularly high-yield sovereigns, to high-yield corporates, for example, a company could run into default during times of stress and fold completely, whereas EM countries would typically receive bilateral and multilateral monetary support, including from the IMF, if the countries show willingness to work on structural reforms.. Even in the worst case, in which an EM country defaults, the IMF will assist in restructuring, which will often result in a high recovery value. Many EM countries also have access to well-established onshore sponsors – from pension funds to insurance companies – reflecting structural demand for their bonds, while others have started their own version of quantitative easing programs.

In addition, consider an EM country’s exposure to one economic driver, such as commodities, compared to a corporate. For example, a drop in oil prices could drastically impact a company’s main line of business and could potentially trigger default. While an EM country’s reliant on oil as its major export could suffer, its multi-faceted economy could have other drivers to curb the shock. It is rarely simply about one economic and/or macro factor for a sovereign, and helps provide greater resiliency than a single business.

Our “country skillset” is completely aligned with alpha opportunity, which is more than evident in the strategy’s performance attribution.

Sticking to our convictions

Once we form our country view, we are not afraid to deviate from the index and benchmark. As an example, for a good portion of last year, we held zero Turkey bonds across our portfolios because we believed the country and its economic policies as unsustainable and lacking in credibility. Another key conviction trade for us is the Dominican Republic because of its reform program, as we believe in the medium term its debt will be upgraded, despite the fact that it is a high-yield country. That is why we actively hold these bonds across our portfolios, with as much as 7% in a single position. Our research emphasis is on where we think the market has been wrongly focused, on what is mispriced, and on how our views differentiate from consensus, so we are able to explore the alpha potential of EM debt.

The trick is to avoid the left tails and the minefield countries. To manage the risk, our EM Bond Strategy is heavily focused on fundamental macroeconomic analysis for the medium term. We identify the trends of sovereign creditworthiness so we are able to anticipate in advance which are deteriorating, avoiding those credits. Part of this means considering only high-yield countries where funding needs have been at least addressed in the short term. As an example, Egypt is another trade we like, given it is well funded for the near future and it also has working relationships with the IMF and structural reformation programs in place.

Another crucial element to our risk-management process is that we’re extremely mindful of liquidity and have a preference for readily tradeable assets, unlike competitors focused on the frontier market (which typically offers very high yield but has higher illiquidity hence demanding a high level of liquidity risk premium). For instance, at the beginning of last year, like so many of our peer groups, we had been overweight risk prior to COVID-19 (albeit in a cautious manner). However, when the virus emerged, we quickly realized it was an atypical event with too many unknowns. As a result, we decisively and swiftly acted to shift to a 10% cash position before the peak of the crisis. Ultimately, it is important to acknowledge the challenges associated with the EM asset class, and that the exit door is often quite narrow given the sudden nature of negative events. That is why we ensure – above all else – that our portfolios have an appropriate level of liquidity.

Our research emphasis is on where we think the market has been wrongly focused, and on what is mispriced so we are able to explore the alpha potential of EM debt.

The Emerging hot spots

In terms of where we see opportunities now, we continue to like the EM hard-currency high yield space, especially the BB-rated universe, as we believe there is value compression, lagging both EM investment grade, and U.S. high yield. Abundant liquidity from the U.S. Federal Reserve’s massive fiscal stimulus has led to greater inflows and higher prices for U.S. high yield, which has supported the relative attractive valuations for EM high yield, to where investors hesitate to flow because of the perceived higher level of risk.

We also predict there will be a trickle-down effect to the EM sovereign asset class over this year: continued accommodative policy from central banks will likely lead investors to buy developed market (DM) bonds, and as their valuation becomes less-and-less compelling, investors will have to start the hunt for yield elsewhere, if they are not already.

Emerging market high yield spreads vs US high yield spreads

Emerging market high yield spreads vs US high yield spreads

Source: Bloomberg. February 16 2021

Another attractive area in the EM fixed income universe is EM currency. We expect economic growth in EM will surprise on the upside as a result of supportive liquidity measures, the increase in vaccine distributions, as well as the conclusion of the U.S. presidential election. In terms of valuation, the EM FX stands out as one of the cheapest asset classes versus its fundamentals. It is also less owned versus other EM asset classes. That is why we like emerging market currencies from the Brazilian Real and the South Africa Rand to the Russian Ruble and Indonesia Rupiah.

Despite the fact that our main strategy is benchmarked to the EM hard-currency sovereign index, we also invest in other subsets of the market because of our varied skillset. One of our trades last year was to overweight quasi-sovereign bonds Pemex (Mexico’s state-owned oil and gas company) versus Mexico sovereign debt, because we believe the sovereign will do everything in its power to support the corporate at its own expense. Another trade was to overweight South Africa local currency bonds because of the steepness of its curve versus hard currency, and attractive domestic currency valuation in the country.

We like the EM hard-currency high yield space as we believe there is value compression, lagging both EM investment grade, and U.S. high yield.

EM to benefit from China-led recovery

On the whole, we believe both EM and DM growth are expected to pick up this year as a result of the COVID-19 vaccine. With EM in particular, the recovery could be faster than expected, based on China-led expansion – a country which has benefited from its own large fiscal stimulus. This has had positive implications for the rest of EM, especially for big commodity exporters like Latin America, and many of its trading partners in Asia.

Over the next few quarters, we anticipate EM debt will benefit from the structurally weakening U.S. dollar, increased economic growth, a gradual recovery in the tourism industry, and a supportive commodity outlook. We are cautious of the possibility for a sharp rise in core DM rates driven by inflation, but it is not our base case. Nevertheless, the virus has changed the macro fundamental matrix for EM, with the fiscal deficit now accounting for 10% of GDP overall, which is not sustainable and will need to be addressed by tightening fiscal and monetary policies at some point in the future, combined with structural reforms.

That said, in summary, we believe the risk/reward scenario warrants investment in EM debt because that’s where the structural risk premium and abundant alpha opportunities reside.

Total return of EM HC index vs US treasuries and S&P 500

1JPMorgan, 2019. January 19 2021

 

Disclaimer

©2021 BMO Global Asset Management. Financial promotions are issued for marketing and information purposes; in the United Kingdom by BMO Asset Management Limited, which is authorised and regulated by the Financial Conduct Authority; in the EU by BMO Asset Management Netherlands B.V., which is regulated by the Dutch Authority for the Financial Markets (AFM); and in Switzerland by BMO Global Asset Management (Swiss) GmbH, which is authorised and regulated by the Swiss Financial Market Supervisory Authority (FINMA). Telephone calls may be recorded.

J.P. Morgan EMBI Global Diversified Index – is an unmanaged, market capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

Investments cannot be made in an index.

Reserved for professional clients as defined by the European Directive 2014/65/EU (“MiFID II”) and is not for retail distribution.

The information provided in the marketing material does not constitute, and should not be construed as, investment advice or a recommendation to buy, sell or otherwise transact in any referenced securities or investment products. Portfolio holdings and allocations may not be representative of the portfolio manager’s current or future investment and are subject to change at any time. The holdings identified do not represent all of the securities purchased, sold, or recommended and you should not assume that these investments were or will be profitable.

The viewpoints expressed by the Portfolio Manager represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. This material does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.

Investment products are: Not a Deposit — Not FDIC Insured — No
Bank Guarantee — May Lose Value

Risk warnings

The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Investing in emerging markets is generally considered to involve more risk than developed markets.

The income and capital due from bonds is dependent upon the issuing country and/or company’s ability to pay and any default will adversely affect the value of your investment.

Changes in interest rates can affect the value of fixed interest holdings and may adversely affect the value of your investment.

Changes in rates of exchange may also reduce the value of your investment.

Use our handy glossary to look up any technical terms you are unfamiliar with.

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