- For many investors, emerging market debt could be viewed as a core-portfolio holding rather than a short-term tactical investment.
- 2013’s re-pricing created value in terms of higher yields, a more dedicated investor base and a better relative value argument.
- Flexibility across the full spectrum of EMD investment opportunities is extremely important, as emerging markets are not homogenous.
By Patrick McConnell, Director, Fixed Income Product Management and James Waters, Client Portfolio Manager, Fixed Income
A dominant theme over the past few years has been the search for yield, particularly when accompanied by low volatility. Given the meager return on cash, investors have been moving into credit in search of additional returns and into asset classes with perceived levels of low volatility. Corporate credit spreads have tightened steadily, in part due to this demand, resulting in a steady return profile for the asset class. The stresses in the corporate credit markets that were readily apparent during and immediately after the financial crisis have all but disappeared. However, investors now need to look beyond corporate credit for incremental yield, and we believe that emerging market debt (EMD) offers an attractive, high-quality alternative.
Emerging market debt is largely investment grade
Hard currency EMD, i.e. bonds issued in U.S. dollars, is effectively a credit asset class and spreads (the yield premium) over U.S. Treasury bond yields can be more directly compared to corporate credit spreads. In fact, on a risk spectrum from 1-10 with 1 being Treasuries and 10 being full-beta high yield (HY), emerging market bonds are around a 7. EMD has effectively transitioned from a speculative asset class to one in which more than 70% of emerging market debt (using a common EMD index) is now rated investment grade (Exhibit 1). In our view, this progression in credit quality supports a shift in portfolio allocation away from using EMD as a short-term tactical investment, towards a long-term core-portfolio holding.
Exhibit 1: EMD: primarily an investment grade asset class
Source: Barclays U.S. EM Sovereign & Quasi-sovereign as of 4/30/2014
Many investors had been increasing their EMD holdings, recognizing their fairly low allocations to EMD relative to the sector’s capitalization and economic importance. However, investor confidence in the sector and its attractive risk-return proposition was unexpectedly tested last year. Yields on EMD and corporate credit, which historically have traded in tandem, moved in opposite directions (Exhibit 2). Spreads on EM countries rated below-investment grade widened versus comparable high-yield corporate bonds. The same dynamic occurred between EM investment grade (IG) and IG corporate bonds. The divergence was particularly acute for HY issuers.
Exhibit 2: Spreads on EMD and corporate credit moved in opposite directions last year
Source: Bloomberg, May 2014.
The 2013 performance divergence came after four years of strong relative performance, so to some extent the correction was a natural valuation pullback. Higher Treasury yields were the initial catalyst for the correction and led to deteriorating technical factors and investor concerns about the impact of more expensive capital on current account deficit countries. Country-specific volatility in countries such as Venezuela, Ukraine, Turkey and Brazil also contributed to concerns about the sector.
2013 created value in a sector with continued fundamental appeal
Last year’s weak performance has created value in the sector, especially in the context of stretched valuations in other fixed-income sectors. Moreover, the fundamental case for investing in EMD remains unchanged. EM economies enjoy better balance sheets and growth drivers than developed market (DM) economies. The International Monetary Fund forecasts EM growth of 4.9% in 2014 and even faster growth in 2015, with EM countries retaining their significant growth margin over DM economies. Although the pickup in DM country growth has yet to flow through to EM countries, we expect that better DM growth and a cyclical upturn in some key EM economies should result in better growth for emerging markets this year and in 2015.
The underlying credit characteristics of EM sovereign issuers vary considerably from highly-rated investment grade entities such as Malaysia, Poland, Chile and Mexico to more stressed high-yield issuers such as Venezuela, Ukraine, Ghana and Argentina. However, the most robust comparison can be made between IG EMD and IG corporate credit due to the lower levels of idiosyncratic risk and lower risks of default.
There are other factors that need to be considered when assessing the relative value between the two asset classes. For example, EMD volatility has been much higher than other spread sectors due in part to the EM bond market being a relatively longer duration asset class compared to most other higher beta credit sectors. This additional sensitivity to interest rates in an environment of rising bond yields over Q2 and Q3 2013 was an unwelcome feature which was then reflected in prices and volatility.
We expect higher Treasury yields over the next year, but not of the magnitude seen in Q2 2013; in any case, we believe the sector is better positioned to weather a rise in yields. We believe duration is less of a concern due to the current level of yields and the steepness of the Treasury curve, which is already pricing in higher term yields over the next few years. Broadly, to have a negative effect, yields would have to move higher than levels already priced into the market. Furthermore, EMD has historically performed well compared to other fixed-income sectors in periods of rising interest rates. If we consider empirical or observed duration sensitivities during periods of rising rates, EMD has usually performed as if it had a duration profile closer to 2.7 years (Source: Columbia Management and Barclays, last 10 years as of 3/31/14) as opposed to the 7-year analytical duration figure reported by the index. Over the last 12 months, the volatility of changes in spread has also been higher for EMD compared to corporate credit.
Recent volatility was mainly driven by a select group of issuers as opposed to the overall market (Exhibit 3). EM HY (i.e. less creditworthy) issuers have had markedly higher levels of volatility, nearly matching the ratio experienced by high-yield corporate bonds in 2008. By looking at spreads adjusted for volatility, we can identify a more interesting relative value comparison between the two asset classes.
Exhibit 3: Spread volatility has been high for EMD over the past year
Source: Bloomberg, May 2014.
A constructive outlook
EMD has transitioned from a market priced for liquidity to a market priced for growth. The volatility of 2013 affected EMD much worse than other fixed income credit sectors against which it is generally compared. But opportunity was created by that volatility (which we expect to normalize back in line with its historic relationships). In our view, today’s environment remains attractive for EMD, underlying fundamentals remain compelling and technical factors are more supportive. However, EMD has become less homogeneous at a credit level. Making the right country calls has never been more important as the status of EM country growth trends, balance of payments sustainability and overall economic resilience is significantly more divergent than it was five years ago. This divergence favors an investment manager who focuses on fundamental country and credit research and has the flexibility to invest across the full breadth of emerging market debt opportunities in order to concentrate the portfolio in the best country ideas, and to implement those country ideas with the most attractive risk-adjusted securities.