Keep clipping the coupon, but be selective

For many, investing is a daunting prospect at the moment. Global equity returns since the depths of the Covid crisis aren’t far off 100%. In fixed income, credit spreads are tight relative to history. Alejandro Arevalo, Head of Emerging Market Debt, argues that emerging market debt (EMD) is less overvalued than many areas, and has the breadth to offer really attractive opportunities if you know where to look – and what to avoid.

After extraordinary performance from risk assets since the depths of the Covid-19 driven market crisis of March 2020, we are at a point where the question “Where should I invest today?” is exceptionally difficult to answer. Equities have risen by around 100% depending on the market. Fixed income returns look weaker in that period by comparison – high yield emerging market credit has “only” delivered 36%, and investment grade emerging debt “just” 16% (equivalent figures are similar for developed markets)¹. Even so, many commentators are pointing to spreads being tight relative to history, and that’s making investors nervous.

We’d share some of that cautious perspective in EMD, but only up to a point. We don’t see a catalyst for a significant drawdown in emerging markets in the short term. Economic growth is robust, and many emerging countries have more room to recover from the pandemic than developed markets. Concerns about the Covid delta variant are falling away. The Federal Reserve is doing its utmost to reassure markets that tapering won’t happen too quickly and won’t lead to immediate rate rises. In any case, EMD has shown itself to be more resilient to higher rates and a stronger US dollar than many used to think. On top of that, when you look at relative valuations in terms of credit spread tightness, EMD is more attractive in valuation terms than equivalent developed market debt.

We aren’t yet seeing the sort of spread tightness that caused us to reduce risk materially just before the Covid crisis hit, and in relative terms we think EMD can continue to perform. It’s really important that at this stage of the cycle, we can expect to see much more dispersion between individual bonds and countries. We are past the early part of the cycle where whole asset classes recovered together from depressed levels. Fuller valuations mean that fundamentals are really important in fixed income. You need to know what you own, and just as importantly, what not to own.

The Chinese real estate sector has been a good example of this year to date, where we have seen significant volatility across the asset class, but most of all in two key names, Huarong and Evergrande. Both have very high levels of leverage; rumours (even if unfounded) about the solvency of these companies, and the reliability of government support, have caused bond prices to swing violently. We’ve started to see dispersion between companies as the bad apples decouple from the rest. That’s a really beneficial situation for active managers like us. We’ve never liked Evergrande, because of its indebtedness, but have preferred higher quality names like Kaisa. In the early cycle when a rising tide floats all boats, that doesn’t matter. Today, it delivers alpha. It’s allowed us to add back to Chinese real estate because that decoupling of “good” and “bad” companies rewards a selective approach.

One of the benefits of investing in EMD is the sheer breadth of the asset class. We were able to avoid the volatility in the Chinese market by being underweight and investing elsewhere, before returning to the region given attractive valuation opportunities. We continue to be very diversified across the globe, though. One area we really like is Latin America. Our strategies have been overweight the region for some time, because of its exposure to the US as the driver of global growth. More recently we’ve added back to Colombia, where some expected downgrades have given us the opportunity to go back into names we like at more attractive valuations, especially compared to credits in other countries such as Brazil. Similarly, in Peru, the new leftist government’s budget was not as harsh as expected and any future action will likely be limited by a more conservative legislature, so we’ve added back there as well.

Other areas we like include Africa, where we are able to find a range of countries with improving fundamentals paired with relatively high yields, making a really attractive investment proposition in our view. Again, we’re highly selective, choosing to own Nigeria, Morocco and Zambia, for example. In Europe, volatility earlier this year caused by fears of war between Russia and Ukraine, and by Turkey’s sacking of its central bank chief, led to valuation opportunities, where we took advantage. Finally, in the Middle East, higher energy prices and regional stability continue to be supportive in Oman, Bahrain and the UAE.

Investors can be forgiven for scratching their heads and wondering where to put their money after such a strong run, particularly in equities. We think that EMD, and particularly EM corporate credit, is too easily overlooked despite very attractive yields and valuations that aren’t as over the top as elsewhere. Furthermore, as a broad asset class that is less well understood than developed markets, it can offer more opportunity for active investors.

^{1 Total returns of MSCI World and S&P 500 indices +96% and +101% respectively. JP Morgan Corporate Bond Index High Yield +36% and Investment Grade +16%. 20th March 2020 to 30 August 2021}