We discuss the nature of this structural risk premium, how emerging market debt can fit into a portfolio and which themes the team is focused on to best capture the returns available to investors at this crucial juncture.
Investing in emerging market debt can be a nerve-racking experience, with events in the developing world often filtering into Western news outfits when crises develop. The current invasion of Ukraine by the Russian military is a case in point, and over the last few years, there were numerous examples of other news events in emerging markets where investors might think investing in this asset class is inherently very risky. Comparing this perceived headline risk with the actual risk taken by investors in emerging market debt, we believe the asset class offers a very attractive risk-adjusted return profile. Our analysis over multiple time frames shows that investors have historically received equity-type returns with fixed-income type volatility. For example, a dollar invested in emerging market debt at the tightest risk premium ever achieved, just before the Lehman bankruptcy in 2008, returned more than safe-haven US Treasuries or developed market investment grade bonds if the investment was held over time (Figure 2).
Figure 2: Total Return Index Level, All Series Rebased to 100 on January 1, 2008 | as of February 27, 2022
One of the most important reasons for this compelling risk-adjusted return capture is the broad range of investment opportunities that can be found in emerging markets. The universe is comprised of approximately 80 countries with a wide range of securities from hard currency sovereign and corporate bonds, local currency bonds, interest rate products and foreign exchange opportunities. The asset class is also well diversified in terms of credit quality. When proxied by rating agency methodology, we find investment opportunities in AA-rated sovereigns trading at very narrow spreads to developed market yield curves, all the way to deep-in-default countries where bonds trade at 10 cents on the dollar. This means that in most market environments, the opportunity for outperformance exists, but taking advantage requires a disciplined approach.
The universe is also constantly evolving as new countries develop their financial systems and are keen to attract capital for development in local and hard currencies. In the last decade alone, we have seen African sovereigns issuing a wide variety of dollar or euro denominated bonds, and Middle Eastern sovereigns and corporates accessing global capital markets keen to diversify their funding away from only domestic borrowers. In the Middle East, sovereign issuance was also motivated by the desire to provide a benchmark dollar bond curve for local corporates to easily access external funding. In local markets only last month, Egypt saw their efforts to join the investment mainstream rewarded by a much coveted inclusion in the widely followed JP Morgan GBI-EM local currency bond index. Furthermore, we have essentially seen the birth and coming-of-age of emerging market corporates as an asset class in its own right, where we find a particularly interesting combination of potential investment opportunities. From a top-down perspective, many emerging market corporates refrained from financial engineering techniques that were so popular in developed markets during the period of ultra-low interest rates. In our view, this means that fundamentals in aggregate have been on an improving trajectory for the emerging market corporate asset class.
Geographical diversification is a major factor for the overall low correlation with developed markets and over most time periods also within emerging markets. Coming back to the current geopolitical crisis, Russia attacking Ukraine, we believe, has only a very limited fundamental impact on Asian sovereign bonds or Latin American corporates. In fact, it is often the case that a crisis in a region or country can lead to capital getting diverted to other investment opportunities, as was the case when investors exited Argentina in 2018 after the victory by a far left candidate in the primaries. Capital was swiftly deployed into other areas within the high yield universe in Latin America and globally. Returns for the asset class in the months that followed were strong, with the 2019 calendar year returning over 15% for the most widely followed Hard Currency Emerging Market sovereign bond index after the modest drawdown of -4.26% in 2018.1
Due to its breath of opportunity and diversity of involved parties—from local investors to globally operating funds, domestic pension funds or insurance companies—emerging market bonds are far from easy to navigate and analyze, and we often find that the market is missing key developments. Our process is explicitly designed to capture these. We constantly ask our team members to answer the question: What is the market missing? At this juncture, this could involve an analysis of what the longer-term impact of the current geopolitical escalation could be on countries far from the frontline in Eastern Europe—such as higher, long-term commodity prices that benefit a diverse range of oil exporters in Africa, the Middle East and Latin America. We often find that in volatile periods, markets move indiscriminately, disregarding longer-term fundamentals. In turn, we look for opportunity amidst the volatility to position portfolios for the long term and to harvest the structural risk premium.
1. Source: JPM. Hard Currency = J.P. Morgan EMBI Global Diversified Index
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