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October 2017

Emerging market debt's balancing act

EM bonds are booming but investors shouldn't forget that these are volatile assets. Mitigating risks can reap better rewards over the long term.

Emerging market (EM) bonds deserve to be a prominent part of a diversified portfolio. As the forecasts in our Secular Outlook show, such securities are among the few sources of potentially attractive returns in an otherwise low-yielding fixed income world.

Unlike expensive developed market debt, EM bonds offer high yields and compelling fundamentals. Even after their strong recent run, local currency and US dollar-denominated EM bonds yield 6.0 per cent and 5.2 per cent respectively. That compares favourably with the 1.5 per cent currently offered by developed market bonds – not least because inflation is rising in advanced economies but falling in the developing world.1

Our strategists are forecasting 8.1 per cent returns for EM local debt and 3.3 per cent for EM hard currency bonds (in dollar terms) over each of the next five years, with the market benefitting from slackening inflationary pressures and solid economic growth. By contrast, we see developed government bonds only giving a total annual return of 1.7 per cent.2

But, as history shows, EM bonds are also likely to suffer sharp swings along the way – volatility that could seriously harm investor returns if it is not properly dealt with.

Too far too soon

EM debt has been on a dramatic run over the past year and a half. Since the start of 2016, the benchmark JP Morgan GBI-EM Global Diversified Composite Index has risen 28 per cent.The money has certainly flowed, too. In the first half of 2017 alone, USD13.5 billion shifted into EM debt exchange-traded funds (ETFs), beating the record USD11 billion that went into the market the previous year.4

Boom times

JP Morgan GBI-EM Global Diversified Composite Dollar Index, total return rebased to 31.12.2015 = 100

boom times JP Morgan GBI-EM Global Diversified Composite Dollar Index,

Source: Bloomberg. Data as of 15.09.2017

There is now a distinctly overheated feel to the market.

For instance, in June, Argentina issued a 100-year bond which drew nearly USD10 billion in bids for USD2.75 billion of supply. That this was only three years since Argentina, a serial defaulter, last reneged on its obligations suggests a uncomfortable degree of market euphoria.

To be sure, there were reasons for buying the bond. The 8 per cent coupon is attractive relative to the alternatives. On a duration basis, the bond was cheaply priced compared to other Argentine securities. And even though the new government looks to be the most prudent the country has had in a long time, it's unlikely that any investors bought the bond expecting to hold it to maturity.

But the market's volte face on Argentinian debt over such a short time also highlights the degree to which investors are willing to overlook significant long-term risks for extra yield right now – successful new bond issues from Ivory Coast, South Africa, Turkey and Brazil are just some of the other high profile examples of such behaviour.

Beware volatility

In times like these it is easy for investors to ignore the importance of taking adequate insurance against the possibility of a market decline. Getting caught up in euphoria can prove costly, particularly in periodically volatile instruments like EM bonds.

Experience tells us the asset class is prone to sharp declines from time to time. For example, between the start of 1994 and end of 2015, the JPM EMBI Global Diversified Composite index suffered 57 weeks during which total returns declined by more than 2 per cent, and 12 where they dropped more than 5 per cent.

These steep market drops can be extremely damaging to long-term investment returns as the deeper the loss, the more difficult it is to recover – a 25 per cent market decline requires a subsequent 33 per cent rally to fully recover ground. What’s more, investors tend to be panicked into selling at the worst possible time, often near market troughs, much as they tend to rush into markets when rallies are already long in the tooth.5

Passive aggression

There are reasons to believe that taking a conservative, risk-sensitive approach to EM debt investing might make more sense in future. That’s because the massive growth of passive investment in EM debt could exacerbate market volatility and make peak-to-trough losses even more severe. A decade ago, hardly any money was invested in emerging market debt ETFs. By mid-2017, they accounted for almost half of the USD90 billion of net flows into the asset class since January 2007.6

ETFs might suit very deep, liquid and largely homogeneous asset classes like US equities, but it is not obvious that they’re sensible investment solutions for markets like EM debt. There are several reasons why we believe the asset class doesn’t lend itself easily to passive investing. For example, the fact that as countries take on more debt, their weighting in market indices grows, forcing index trackers to take ever larger positions in what are likely to be ever riskier assets.

Then there’s the question of whether the EM debt market is truly efficient. Unlike equities, bond markets tend to have significant numbers of participants whose aim is not to maximise profits, not least governments and quasi-governmental agencies. These can open up opportunities for active investors that passive strategies can't exploit.

oscillating em Debt

JP Morgan EMBI Global Diversified Composite Index, per cent weekly total returns

BEWARE DRAWDOWNS JPM EMBI Global Diversified Composite Index per cent drawdowns

Source: Datastream. Data from 31.12.1993 to 11.12.2015

And that’s not to mention the costs of trying to track indices full of infrequently-traded bonds, or the question of how representative these indices really are of the emerging universe. Added to that is the fact that many passive ETFs don’t capture many attractive issues from excluded countries – the indices have been relatively slow to promote frontier countries into the next rank, for instance. 

It’s also worth bearing in mind that EM debt index funds don’t track the standard JP Morgan GBI-EM GD index but instead follow a variant. For the standard index there is no minimum country exposure, but for the variants that ETFs follow, the minimum is between 1.5 and 3 per cent. This matters because as new countries enter the index, the ETFs that track the benchmark are often forced to hold an uncomfortably heavy weighting in what are usually less liquid bonds. This tends to make index-tracking funds less liquid than those following the standard benchmark. Index-trackers also have no way of making up transaction costs and taxes levied on foreign investors, so will tend to lag their indices, sometimes significantly, particularly during market declines. 

Conservative solutions

Pictet Asset Management’s EM debt strategies aim to outperform their reference benchmarks over the long term, in part by ensuring they can preserve capital during periods of market volatility. This isn’t because we are constitutionally defensive – we take risks appropriate for the market circumstance – but because we are sensitive to extenuating macroeconomic and political factors and to extremes of sentiment. This explains why we’ve been cautious during the past few months. We find that while our investors might sacrifice some performance during bull runs, they reap rewards by riding the cycle, and holding on to gains when markets become turbulent.

Minimising capital losses during bear markets helps investors to avoid selling at the worst possible moment – which is to say after a substantial decline. But by the same token, cautious asset managers are less likely to participate aggressively in frothy markets, and thus tend to underperform during periods of generalised overconfidence.

Pictet AM's global hard currency debt strategy tended to outperform the benchmark index during periods periods of significant drawdowns since June 2007, most notably during the 2008 crash, when the index dropped by more than a fifth.7 It also recovered quickly. This has helped to shore-up long run performance. Over the past decade, the average annual performance of our hard and local currency strategies have beaten their benchmarks.8

beware drawdowns

JPM EMBI Global Diversified Composite Index per cent drawdowns

OSCILLATING EM JP Morgan EMBI Global Diversified Composite Index weekly total returns

Source: Mercer. Data as of 30.06.2017

Our conservative, prudent process was developed to suit the dynamics of this attractive but volatile asset class. We look at a number of factors as we weigh our investments. One is sovereign risk. Although our primary focus is bottom-up analysis, we use our economic team’s models to properly assess macroeconomic risks facing emerging markets.

This matters because we believe around half of EM debt returns are led by macroeconomic factors. The economic overview complements our detailed bottom-up analysis both of countries and instruments in question so that the result is a rounded picture of risks and opportunities in the asset class.

We treat different components of EM risk individually. For instance, in local currency debt, we manage interest rate and foreign exchange positions separately. During periods of market stress, we carefully control our liquidity positions using a five step process we call “the drill”.9

So when the market hits a rough patch, which could happen sooner rather than later, we’ll be ready. And because we are ready, investors will find it easier to ride out the cycle. Those who are confident enough to stick with the asset class during the market’s inevitable gyrations are likely to do well out of EM over the longer term. But for that to happen they need to avoid bailing out during market panics. And the best way to overcome that psychological trap is, in our view, to invest with portfolio managers who work hard to preserve capital.