By David Dowsett
While some areas of traditional fixed income appear to have become less favourable in the current environment, we haven’t seen a complete rotation out of the asset class and do not believe this is likely to occur. Furthermore I do not see this trend changing once the Fed starts raising rates.
However, what we have seen is movement within the asset class as astute investors turn their attention to higher-yielding areas of fixed income. We are seeing this borne out in their appetite for emerging market (EM) debt. At present, according to Bloomberg, the average yield available in core European fixed income is less than 1%, whereas within EM debt it is around 6% which is an immediately attractive alternative, despite the headlines and negative sentiment around the asset class.
More recently, there has been increased volatility in the local currency segment of the market. As a result investors are accessing the market without being exposed to currency risk. They are taking a blended approach to EM hard currency debt, an EM aggregate strategy, which is giving them exposure to all the benefits of investing in EM across sovereigns, quasi-sovereigns and corporates, but without the additional risk from EMFX.
As an aggregate EM credit strategy such an approach is exposed to higher-than-average spread and default risks. However, the reduced volatility through diversification (and lack ̼of currency risk), higher yields and the ability to tactically allocate across divergent return streams across various sub-sectors has added value for investors seeking to diversify their portfolios. An aggregate debt strategy can also be used as an asset allocation tool within the hard currency EM debt universe.
The hard currency EM universe (sovereign and corporate debt) has evolved significantly over the last few years, growing in both size and diversity. The JP Morgan EMBI Diversified comprises over 60 countries at various stages of development – from frontier markets such as Tanzania to more mature markets like Mexico, and is approximately US$700 billion in size. In addition to the sovereign credit itself, the index also allows access to a vast array of sovereign owned quasi-governmental entities in wide-ranging industries.
EM corporates on the other hand are typically domiciled in the more ‘developed’ EM countries which have successfully developed institutional and legal frameworks and deeper capital markets. The EM corporate market (as represented by the JP Morgan CEMBI Diversified) is an exciting mix of issuers from a variety of industries and countries, with the market currently estimated to be around US$1.7 trillion in size. In addition there is close to US$300 billion gross issuance coming from EM corporates every year – larger than the US high yield market and the EM hard currency sovereign market – providing an ongoing influx of new investment opportunities.
The combined characteristics of these two markets provide access to the broadest range of hard currency bonds in existence; from the early ‘frontier’ sovereigns to large companies that are household names such as Hyundai or Gazprom. The total universe is also well-diversified by country and sector and offers investors higher yields, simpler capital structures and lower leverage than developed market counterparts with an average credit rating of investment grade. The spread and carry of the EM sovereign and corporate sectors relative to developed market are also attractive from an investment perspective.
A trend we have witnessed as EM debt markets mature is the increasing differentiation in the performance of countries and sectors, which offers investors the ability to capture significant alpha generating opportunities. Although I would caveat that due to the size and scope of the market, investors need to ensure they carry out thorough research and due diligence before accessing this market. I think this differentiation theme looks set to continue in the medium term within EM and between EM and developed market debt.
Whilst not without its risks, accessing this universe via an aggregate EM credit strategy is an option worth considering and, once the ‘shock’ of Fed rate rises has filtered through, the headlines around EM might start to look less negative.
David Dowsett is co-chief investment officer and co-head of emerging market debt at BlueBay Asset Management
Comments