Roundtable

Emerging market debt

portfolio institutional looks at how investors are approaching emerging market debt as Covid hits local economies hard.

December 2020

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Emerging market debt roundtable

The emerging markets are no place to take a general view. Seasoned investors will know that political instability in Venezuela will not put a question mark over China, India, Brazil or South Korea’s ability to repay their debts.

Nothing will prove that there is little connection between many of the economies in the developing world than the Covid pandemic. Some countries will recover faster than others from impact of the virus and the challenge for investors is to spot the winners during a time of such uncertainty.

Indeed, as many countries across the world were put into lockdown, investors sold billions of pounds worth of emerging market bonds. The initial outlook from rating agencies did not help as sovereigns in the region have experienced more than 70 downgrades this year.

But did they move too soon? Spreads have improved since the sell-off and in September rating agency S&P announced that it expects emerging markets, excluding China, to bounce straight back by growing 6.2% in 2021 after predicting a contraction of 6.4% this year.

Investors have turned to emerging markets to gain exposure to the economies that are driving more than half of the world’s growth and to escape the low rates and yields on offer in the developed world. Yet this is a riskier area of the fixed income universe. Default and liquidity are not the only risks, currency exposure also needs consideration as movements in exchange rates could wipe out any gains earned.

So, this vast collection of markets needs experienced investors and fund managers to navigate through such diversity of issuer and risk. In this supplement we take a closer look at the emerging market debt universe and find out what strategies the experts are following.

Driven by strong fundamentals, emerging markets have provided an antidote to the developed world’s low return environment, but is Covid changing that? We spoke to institutional investors and an emerging market fixed income fund manager to find out how they are approaching these markets.

Watch a video of the discussion here

The discussion

portfolio institutional: How are you accessing emerging market debt?

Samy Muaddi: This year feels different in many ways, but we can still use the framework that we have been using for more than 30 years in emerging market debt. It is a framework anchored in applied history as it is informed by almost 200 years of sovereign issuance.

Sovereign credit health is first and foremost what you need to look at. While we can be bottom-up on the corporate side, where there is a diversity of financial services, telecommunications and energy credits, when something goes wrong on the sovereign side correlations go to one in a country and you no longer get that diversification from corporate bonds.

So, it is a mixture of bottom-up and top-down. Bottom-up analysis is what guides us, but when something goes wrong in a country, as is happening in many cases in 2020, that top-down overlay becomes increasingly important.

Krzysztof Lasocki: Emerging market debt is a risky asset class where it is expensive to generate higher than average risk-adjusted returns. We have always liked active management in this asset class, which allows for dynamic switching between local and hard debt, between corporates, high yield and investment grade as well as the ability to go long and short, particularly on currencies.

It is an asset class we are cautious about this year, but there are opportunities. If not in investment grade, then in high yield and even in the distressed space.

Chetan Ghosh: We have an 8% allocation to emerging market local currency debt. That is implemented through an active manager who has the flexibility to go into hard currency and corporate debt as well, but that is more on the margins than being a central part of the allocation. They can go up to 30% off-benchmark.

Philosophically, we like our assets managed by managers who think carefully about dynamically altering the level of risk they take depending on the opportunities available. So, they put their foot on the accelerator if they are getting well rewarded for risk and hit the break if everything is expensive.

That is particularly salient in emerging market local currency debt, which is a volatile asset class where you can get unduly hurt by currency fluctuations.

Over time we have heard some managers say that we are in for some short-term noise, but the parameters of the fund do not allow us to protect capital for you. We explicitly sought an approach that when managers needed to defend capital they have the levers to do so and when the opportunity presents itself they are mentally geared to take advantage.

One of the reasons we are in local currency debt is because of the strategic ambition that we could benefit from currencies appreciating over the longer term.

The best returns occur when things transition from terrible to bad.

Samy Muaddi, T. Rowe Price

Alan Pickering: Over the years, the dilemma that I as a trustee have had is whether to split particular asset classes geographically or not. Fashion has ebbed and flowed over the years. On occasions, schemes have wanted to invest in an asset class without imposing too many geographical constraints, while at other points in  the evolution of different schemes they have been willing to compartmentalise asset allocation by type and region.

Most defined benefit schemes I am involved with are moving closer to risk transfer from the employer to an insurer. As they do that, they are looking for income generators with a fair degree of liquidity. We are in a lower for longer environment and those deploying income seeking asset classes on our behalf are being encouraged to look worldwide but through a lens which has an ESG flavour to it as well. That can be a challenge in certain markets.

PI: What classes of emerging market debt are you favouring during this pandemic?

Muaddi: Our bias has been towards hard currency debt. In theory, currencies should appreciate from productivity gains, collapsing inflation differentials and central bank independence but that has not played out.

Statistics support this argument. If you take hard currency emerging market debt in sterling terms, since 1993 you would have generated a return of 9.3% per year, which compounds to around 980%.

The return from local currency-denominated equities would have been 5.75% per annum. When you compound that there is a cumulative difference of 630%.

The bond side outperformed the stock side, which is atypical for countries. Hard currency emerging market bonds have outperformed local currency-denominated emerging market stocks in about two-thirds of rolling three-year periods.

Currency depreciation has been a release valve for countries as they have gone through the necessary growing pains of managing external pressure. We do not see that changing.

So, our bias is towards hard currency debt to compound interest. More specifically, our more nuanced contrarian view is that a core approach to emerging markets should include corporate assets.

When you dig into the data, the corporate market’s composition is significantly more defensive and allows for better interest compounding.

Lasocki: We still look favourably on soft currency debt. At some point the multi-year US dollar bull-run must end. Some US assets are behaving slightly different than we might have expected a few years ago.

It is important to remember that the currency effect may wipe out these attractive returns. This year some of the biggest losers in the local currency debt space were countries with solid, high single-digit returns which were wiped out by double-digit currency losses. So, it is important to hedge the currency or at least manage it actively through currency markets.

Pickering: If this asset class is to find a home in the defined contribution space then a trustee’s starting point will be to hedge the currency. It is difficult to expect DC members to take too many variables and getting the right asset class return is hard enough without trying to second guess the effect of currencies.

PI: How are emerging market economies recovering from the pandemic?

Muaddi: When you look at the 200-year history of emerging sovereign nations issuing debt internationally, there are four ways a country can go through a period of stress: fiscal risk, external risk, institutional degradation and contingent liabilities or the off-balance sheet factors that will be socialised in a crisis.

Covid permeates through all four those, but the one that is most acute in 2020 is the fiscal side. We are going to see a large, one-off increase in debt-to-GDP. It is going to take three to four years at best for countries to regain where they were from a debt sustainability perspective.

The silver-lining is getting the bad news out front and then learn how to deal with it. The good news is that multilateral aid programmes have been announced as bridges to liquidity. Ultimately, after this necessary fiscal push in 2020 there will be a period of consolidation of finances for emerging market countries.

By and large, the mainstream emerging market countries, particularly in Asia, entered with enough balance sheet space to absorb this fiscal shock.

We expect defaults in frontier markets. There have been five in the past 18 months and three of those were not Covid related. We could potentially see another three to five in the next 24 months.

That is small enough to stock pick around and should not contaminate the broader outlook for the asset class.

There are opportunities which will emerge from the recovery and investors will be expecting a lot from China and Brazil in the coming months.

Krzysztof Lasocki, Royal Mail Pension Plan

Ghosh: On the point about debt sustainability getting back to precrisis levels, we are hearing from our manager that emerging countries may come out of this better in terms of the hits to their GDP than developed markets. We might see positive growth in some countries.

On a relative basis, is there a strengthening versus developed markets? That will be an interesting dynamic to track over the next three to four years as debt sustainability also applies to developed market countries, probably more acutely than their emerging market peers but they do not get punished as much.

Most of these countries are close to fully open in a way that most developed markets are not. You would be surprised at how open Brazil is despite the number of cases reported as being sky high.

No one knows how this will pan out. It will be three to four years before we see who the winners and losers within emerging markets are and if emerging markets weathered this better or worse than developed markets.

Pickering: It is not sensible to regard all emerging markets as being homogeneous and all investment opportunities within each of those markets as identical. We need to use managers who are adept at cherry picking within market segments, within sub-sets of industries and sovereigns within those market segments. It is hard to know how particular industries or territories are going to emerge from the epidemic.

PI: Is the worst yet to come, Krzysztof?

Lasocki: I am not brave enough to set a date for a full recovery. There are countries that will emerge stronger and even the timing will be different. China’s recovery is on a different trajectory than Peru’s, for example.

The underlying characteristic of emerging market debt, which is fascinating, is that there is such a wide spectrum of countries and the number of issuers is huge. There are opportunities which will emerge from the recovery and investors will be expecting a lot from China and Brazil in the coming months. There are reasons to be optimistic, but globally we know as little as everyone else.

Ghosh: I agree that this an idiosyncratic universe, so you cannot talk generally. What that manifests as is giving your manager as much license as possible to express their idiosyncratic views and choices.

Particularly in local currency emerging market debt, the composition of the index forces you to have high weightings in countries you might not like. That presents a problem for managers in that they can hold zero in one country, but it is hard for them to hold zero in two within that index.

Having mandates that allow managers to access hard currency, corporate, frontier debt or hold cash in times of trouble gives them the flexibility not to stick rigidly to the benchmark.

Muaddi: The benchmark in emerging markets, in all asset classes, is a horrid starting point. Fixed income benchmarks reward highly leveraged countries and companies that have more debt.

So, if Apple has a higher market cap it gets higher index weight. If Argentina has more debt it gets a higher index weight. It is perverse.

The best thing I have done in my career is to ignore the benchmark. I have about an 85% active share. There are around 80 countries I can own and typically invest in 25 to 27 of them.

The country has to earn your clients’ capital, it is not the other way around. A developed nation goes through a crisis in a different way than an emerging market nation.

When something goes wrong in the United States or Europe government bond yields fall. When something goes wrong in South Africa or Turkey domestic government bond yields rise.

That is the difference between an emerging nation and a developed nation. Even though emerging countries have lower levels of debt and can get their fiscal policies in order faster than developed markets, the problem is that they cannot afford it when rates are going higher. They do not have the luxury of working things out over a longer period.

We have to accept reality, but it should not stop us from investing. The best returns occur when things transition from terrible to bad. When a country is in a crisis and transitions towards a degree of stability is the biggest point of value creation in emerging market debt.

The days when emerging market debt is going to be out of kilter with other markets in a sell-off are potentially no longer with us.

Chetan Ghosh, Centrica Pension Schemes

PI: What conversations did you have with your clients during the emerging market debt sell-off in March, Samy?

Muaddi: We had a weekly dialogue with our clients, who used it as an opportunity to provide liquidity. That was rewarding for them as returns are up by 25% since the end of March. This is an asset class that has rewarded a contrarian mindset.

Emerging market debt has a coupon of roughly 6% in US dollars. You will earn that coupon historically in three of 30 years. In 27 of the 30 years you did not earn the 6% carry. You can compound over a longer period, but seldom in a single year do you earn the exact coupon, which is the nature of the emerging markets.

If you have a view that defaults will remain suppressed, I would encourage you to be a liquidity provider because, inevitably, these bonds will pull to par and you earn a coupon plus return.

Lasocki: This is a great point. It is one of the problems with investing in bonds. For many, passive investing may sound appealing, but this is exactly what you should not be doing with your bonds if you are a long-term investor.

Pricing this year has been unprecedented as spreads went up to 600 to 700 basis points and they are still significantly lower by a half, but we are talking about levels we saw in 2015 when China scared everyone with their renminbi devaluation.

That was scary then, but we feel safer now, so it is relative. From a long-term investment perspective, it would not be prudent to take those decisions when something like March happens again. Patience is required in emerging market debt.

Ghosh: In the first half of the year, our manager was down 3%. Compared to high yield, bank loans and the credit spread component of investment grade that stacks up well. The days when emerging market debt is going to be out of kilter with other markets in a sell-off are potentially no longer with us. People recognised that some balance sheets are not as scary as they might be in developed markets, that the yield is likely to still come and it did not sell-off in a basket case way.

On the point of it being an idiosyncratic game, we allow our manager to access frontier markets, which have been a positive contributor to performance in the first half of the year. They have generated positive returns while wider local emerging market debt has sold off.

PI: Are the schemes you work with bullish on emerging market debt, Alan?

Pickering: I would not say they are bullish, but trustees are increasingly willing to have a dialogue with their consultants and asset managers to take a contemporary forward-looking view of all asset classes.

What irritates me is the mantra that diversification is a free lunch, which suggest that it is something of a silver bullet. That is too simplistic and if you are seeking to avoid correlation you need to take a forward-looking view rather than believing that random diversification equals a four-course free lunch. It is not that easy.

PI: This is a crisis and people see opportunity in a crisis. Where are you seeing the opportunity in emerging market debt?

Muaddi: I would cast a wide net when looking at emerging markets. An investor should consider a larger allocation to corporates, if not make emerging corporates your core and sovereigns your satellite. The key differential is Asia credit.

When you invest in emerging market sovereigns you typically have a higher weighting towards frontier markets. We have seen several defaults in frontier markets and they could happen again.

Whereas with Asia credits – China, Malaysia, Korea, Singapore, Thailand and India – we are more comfortable with the macro-economic framework of the four pillars of emerging market sovereign risk. We can earn additional yield and potential capital appreciation by going into the corporate market.

Usually the problem with emerging markets is that in a bad year, investors lose more than the coupon. When you look at Asia credit in a drawdown you rarely if ever do you lose more than the coupon, so a bad year is a zero return or a +1% or -1%. That allows you compound interest over a longer period of time. Covid being first in Asia, first out of Asia was a good stress test and Asia credit held in place relatively well. It goes back to the pillars of macroeconomics that provides a stable foundation to go and extract additional yield premium in the corporate market.

Lasocki: At the risk of sounding adventurous, the most important opportunities are always in the distressed and recovery space. There is always an interesting story there.

There is an ongoing situation in Zambia, although it is difficult to be super optimistic about it. Then there is Ukraine, Argentina and Ecuador.

In the emerging market corporate space there are always a few strong names. In general, I like emerging market corporate because even in high yield, if you compare the US with emerging markets on average the expected recoveries are significantly higher in emerging markets. Defaults are significantly lower because since 2015 a lot of emerging market corporates had to de-leverage to make their balance sheet healthier, while US corporates did the opposite.

It is simplistic to look at emerging market debt and think it is risky because it is emerging markets. To some extent it is risky to invest in UK equities.

PI: Chetan, are you tempted to move into corporate debt?

Ghosh: Our governance model is to defer that decision to the manager. On a relative basis, they have a preference for corporate and hard currency debt.

Having seen high yield and loans retrace significantly post the March lows, hard currency emerging market debt has not tracked it as much in terms of the rebound.

So, we are starting to see a divergence in expected relative returns, which is something we may act upon in the next couple of months.

Pickering: There is a growing recognition that for career-long members of defined contribution schemes we are going to have to find sensible ways of helping them access the growth opportunities in emerging markets. The challenge is going to be how much discretion to give our sub-contracted managers in those markets, either to trade between asset classes and, where bonds are concerned, determine which territories around the world to invest in.

There is a need for us to devote intellectual capital to find how best to allow defined contribution members to benefit from the asset classes which were traditionally the preserve of the defined benefit scheme.

PI: Taking a step back from Covid, what impact has China joining indices had?

Muaddi: I would like to make a controversial comment: China is no longer an emerging market.

When Covid hit China, Chinese government bond yields went down. When Covid hit Italy, Italian government bond yields went up. So, which one is the developed nation?

China still has plenty of progress to make, but from a macro-economic foundation they control their own monetary independence which affords many degrees of freedom in managing fiscal, payment or global healthcare shocks.

China’s current account surplus has gone down and will probably continue to go down given the trade tensions. Rather than leak out FX reserves they are looking to gradually bring capital into the country.

That in combination with the one belt one road initiative is part of a long-term plan to internationalise the renminbi and make it a reserve currency.

A reserve currency is the great privilege of nations. You can export paper and import everything else. It will be a well-managed transition because they have their eyes on the long game.

Ghosh: Our fund manager runs an unconstrained approach so when China hits the bond indices there is not going to be an overnight step change for us. It will have a material impact on managers who are more closely aligned to benchmarks.

Pickering: In the long term, China is part of the solution rather than the cause of the problem. The challenge is to manage the transition in a way that does not do any collateral damage to China or world markets.

It is not sensible to regard all emerging markets as being homogeneous and all investment opportunities within each of those markets as identical.

Alan Pickering, BESTrustees

PI: Has transparency in emerging markets improved?

Muaddi: On the sovereign side, in the past 20 years there has been broad institutional improvement. Indonesia’s central bank today is seen as independent and credible. That would be a wild thought in the 1990s.

However, there is reduced transparency in some frontier markets, especially those borrowing from Chinese development banks or Middle East sovereigns. I would put Turkey into that bucket as well.

On the corporate side, the improvement in transparency has been unequivocally positive. As the capital structures for emerging market corporates have globalised, they have gone from being banked within their country to being banked abroad and that puts a higher standard on transparency. There is still room for more progress but in the 15 years I have been doing this, corporate transparency has never been better.

Lasocki: This is great for emerging market debt investment in general. The more transparent they become the more likely we are to invest in them and that makes them likely to become even more transparent.

There are exceptions and challenges. They are emerging markets for a reason and you have to tread carefully.

It is not just transparency, but the overall engagement issue. In terms of governance this is important. From what I am hearing from our investment managers, engagement is difficult, but it is more direct. Larger managers having access to the governor of the central bank, finance minister and CEOs of large corporates is possible in emerging markets.

Pickering: We are moving from a world of advertising department rhetoric to an investment manager engine room when it comes to transparency.

It is a two-way road to salvation in that the better governed countries and corporates are the more accessible they are to institutional investors. If we as institutional investors can provide them with capital at appropriate times it should be a win-win.

I am, therefore, a multi-national internationalist in trying to make sure that we seek to continually improve governance, transparency and inter-dependence.

Ghosh: This story that emerging market transparency is a whole lot worse than developed markets does not wash with me. I am not sure as to whose advantage it is to keep propagating that story, but we do not have a massive differential anymore.

We have accounting incompetencies and frauds in developed markets and the same happens in emerging markets. There is not that much difference in the frequency of these events. It is an issue of 20 to 30 years ago. Over the past 10 years it has been at the margins.

Muaddi: Before I was a portfolio manager, I was an analyst covering emerging market banks. I was asked to look at European banks during the financial crisis because that was more of an emerging market skillset. The most trouble I have ever had as an analyst looking at accounting was with Irish banks.

PI: It has been a year we will not forget, but what is your outlook for emerging market debt in 2021?

Muaddi: The asset class has earned optimism with more than 9% returns in sterling for a quarter of a century. You will not get the same kicker from government bond yields declining going forward.

That wedge from treasuries or gilts has evaporated, but the margin over the risk-free rate is largely unchanged. I am therefore optimistic on not only a one-year view but with the long-term prospects of the asset class.

Lasocki: I am cautious, but I am cautious about every risky asset class right now.

However, as an institutional investor we cannot sit on negatively yielding cash and wait for the storm to pass. We have to find opportunities.

We are not looking at emerging market debt differently than we were a few months ago. If it is a risky asset class there will still be opportunities. If we divest that would be purely on risk-return grounds and that opportunities could be more attractive elsewhere, but I would not be afraid of emerging market debt just because the pandemic might hit them harder than developed markets.

Ghosh: The asset purchases and quantitative easing by central banks in developed markets are going to force investors to carry on the hunt for yield.

Emerging market debt provides some of the highest yields on offer, particularly versus the credit rating or risk involved. That could create a heavy technical tailwind for the asset class.

Pickering: Most of my defined benefit schemes are looking for yield as they move towards lower dependency on the sponsor. Yield has an important role to play in the risk transfer to the insurance market.

Trustees and their consultants should not turn a historic prejudice into a permanent principle. Our consultants have a duty to make sure we look even-handily at all forms of debt and in so doing determine whether emerging market debt has a role to play on a scheme specific basis as each of those schemes move to their destination, which in DB land is risk transfer to the insurance market.

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