The USD 18.9 trillion emerging debt market is highly diverse and yet remains under-invested by foreigners despite currently offering good valuations, low default rates and better risk/return potential than emerging equities.
- A diverse, yet largely overlooked universe whose composition is shifting
- Low default rates similar to those on US high-yield bonds, and high recovery rates
- Despite expected volatility, the economic picture in 2019 is unlikely to impede the performance of emerging debt
- Local knowledge and expertise are critical to managing emerging debt assets effectively
Emerging market debt has matured from being a marginal choice in major institutional investors’ portfolios to having greater prominence through direct investments or multi-management funds. It has even become a core portfolio investment that now better reflects the size of the emerging debt market. When all asset classes are included (local and hard-currency government and corporate bonds), the market has doubled from USD 9.3 trillion in 2010 to USD 18.9 trillion in 2018 (vs. USD 1.2 trillion for dollar-denominated high-yield bonds (US HY, based on the ICE – Bank of America Merrill Lynch index). We think this justifies taking a new look at investing in emerging debt.
Our integrated approach to managing emerging market debt
The old way of thinking – choosing an emerging market mainly on the basis of its macroeconomic criteria and investing in its equities, bonds and currencies – just won’t do anymore. In fact, our team is no longer organised geographically, but by asset class (corporate debt, government bonds in local and hard currencies, and currencies).
What’s more, the team includes 11 different nationalities and most of our specialists come from emerging markets themselves. The fact that they or their colleagues have gone through (and learned from) emerging market crises makes it possible for us to take factors into consideration other than mere valuation criteria or the quest for yield at any price when investing.
Lastly, our local investment teams in the main emerging markets provide us with clear added-value with their knowledge of local investor flows. We consider these far more relevant than international flows, particularly for local-currency debt.
Our investment principles
The benchmark indices of our emerging debt strategies are highly diversified, covering some 70 countries. We replicate systematic beta, but we deliberately focus on active positions, generally, in 20 to 25 countries. At almost USD 5 billion at the end of 2018, the scale of our assets under management means we can take on large enough exposures to have an impact on performance, without disrupting the markets, even in frontier countries.
Our approach is contrarian, which entails a high concentration of exposures, but can also lead us to sit out the last phase of a bull market.
Taking on aggressive positions versus the benchmark rather than diversifying also requires thorough risk management. A stop-loss is set up for each position and is adjusted to each asset class. If the market is highly liquid with low transaction costs, the position can be unwound rapidly, even in the event of a slight decline. When the market is illiquid, we set an ambitious target so that we don’t have to rush for the exit at the slightest mishap.
Lastly, we integrate ESG (environment, social and governance) criteria into our portfolios. The rating process (for 90 countries) is currently being revised in cooperation with BNPP AM’s Sustainability Centre.
A broad, diversified - but overlooked - universe
The doubling of the emerging debt market in size in less than 10 years mainly reflects a shift in the breakdown of debt, with the share of bank loans receding because of changes in regulations on banks’ prudential ratios. Governments and companies in emerging markets have therefore had to seek financing by issuing debt instruments on the markets.
Default rates are not significantly higher on emerging debt than on US HY debt. The default rate on emerging HY debt was 2.0% in 2017, which is low. Sovereign defaults are also uncommon. Recovery rates are generally high in ‘small countries’ that are assisted by the IMF in their decision to default.
A review of total annual returns of the various emerging debt segments shows this is not a uniform asset class. The macro and microeconomic factors behind shifts in each segment vary greatly. Moreover, the sudden drops on some markets in the summer of 2018 did not spill over into other geographical markets or other assets. While idiosyncratic risks remain in certain countries, there is no longer any systematic risk, in our view.
Exhibit 1: Index returns
Source: JPMorgan, BNPP AM; Feb 2019
Lastly, steep drops in emerging debt (i.e. of more than 10%) have generally been followed by an appreciable rally, very seldom by another decline – hence our contrarian approach.
Exhibit 2: A noticeable rally often follows a drawdown of more than 10%
Source: BNPP AM; Dec 2018
Another reason for our contrarian approach is foreign investors’ marked underweighting of emerging debt and in particular Chinese debt, despite China being the world’s third-largest bond market and the largest emerging bond market. As the inclusion of onshore Chinese sovereign and quasi-sovereign bonds in global bond indices from spring 2019 is likely to generate heavy inflows, foreign investors’ current 2%-3% of total holdings could ultimately rise to 12% or 13 %, comparable to that in South Korea, for example.
In 2018, the emerging debt market underperformed significantly due mainly to:
- The US Federal Reserve’s decision to raise its key rates by 100bp and concerns that there was more to come. Chair Jerome Powell’s recent statements show that this risk is mostly behind us. However, it is still possible that the Fed’s forward guidance, which has become a little less assured, could cause expectations to fluctuate and hence trigger disruptions in emerging assets.
- Tensions between the US and China over customs duties. Relations between the two countries could see further ups and downs that could trigger erratic shifts in the markets.
- Idiosyncratic risks remain in countries such as Argentina and Turkey, whose economic fundamentals are still poor, but these risks do not apply market-wide.
Given the above, we expect 2019 to be volatile, but the economic environment is unlikely to impede emerging debt performance. After a topsy-turvy 2018 and markets pricing in too much bad news, we should see a gradual, modest improvement in economic growth in a still-favourable interest-rate environment. After the rally in all risky asset classes so far this year, we have a conservative stance on the near term, but emerging debt valuations still look good. Emerging debt can offer investors a more attractive risk-return than emerging equities, and we feel that now is the time to take a new look at emerging debt when considering one’s asset allocation.
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