To date, 2021 has shown that being prepared for the unexpected is a huge part of Emerging Market Debt (EMD) investing. The market expected a boom, but indices are in negative territory. High-profile news stories have driven localised volatility. Alejandro Arevalo, Head of EMD, attempts to make sense of what’s been going on, and explains how he aims to deliver alpha this year and beyond.

All eyes were focused on EMD in 2021: the weakening dollar, pandemic recovery, and more accommodative US foreign policy under Biden were added to structural EMD strengths of access to economic growth, relative yield advantage, and strong bottom-up issuer stories.

It’s a rates story

So why hasn’t EMD performed as expected so far this year? It’s because it’s been a rates story – the key driver of performance has been US interest rates. The shift higher in US rates hurt EM investment grade and sovereign bonds, in particular: the sovereign index, which has much more duration than the corporate index, was down 5% at its lowest point in March, and investment grade credit troughed at -1.9%, while high yield credit was in positive territory. In April, when US rates rallied, the sovereign index was up over 2%.1

US rates explain EMD returns so far in 2021

US rates explain EMD returns so far in 2021

Source: Bloomberg. Total return of US treasury note 1.625% coupon expiring 15.02.26; Bloomberg Barclays US Corporate Bond Index, JP Morgan EMBI Diversified Composite Index, JPM CEMBI Broad Diversified Index, JPM CEMBI Diversified High Yield Index

A series of surprises

The other key part of the story this year has been a succession of surprise events, all unconnected with each other, but all driving volatility. In mid-March, President Erdogan of Turkey sacked his market-friendly central bank chief for being too market friendly. As a result, the lira lost 15% in hours. Then, in early April, we started to read rumours on social media during a company reporting blackout period that Chinese state-owned enterprise Huarong was preparing to default on its overseas debt. While the rumours turned out to be nothing more than scurrilous gossip, the bonds nearly halved in value in the first half of the month. Evidence of a build-up of armed forces and materiel on the Russia-Ukraine border led to fears that the conflict that has been rumbling on since 2014 would explode into all-out war; subsequently, bonds sold off in both countries. Most recently, in Peru, the Leftist candidate Pedro Castillo won a surprise first-round victory and looked more likely to win the second-round run-off. Peruvian assets sold off materially in response.

Contagion is a thing of the past

So, instead of inflows and strong performance year to date, we have seen plenty of noise across EMD, from rising US rates to several idiosyncratic surprises. What does that mean for the asset class going forward?

Taking a step back, there are reasons to see positives for EMD in this year’s returns. That the key driver of performance has been the selloff in US treasuries is a sign of an asset class behaving just as you would expect developed market credit to do. Furthermore, all four idiosyncratic events have been resolved smoothly – with the possible exception of Peru, where the second ballot has still to be fought, though the polls have narrowed. There has been no contagion in any of these regions, or across the asset class.Our key conclusion from this year so far is that everything we have seen is pointing to EMD’s increasing maturity as an asset class. The shocks and trauma we used to see in the asset class have become a thing of the past. At the same time, EMD is one of the few places left for investors to find a healthy level of yield: 5.0% in the case of the sovereign index, and 4.3% for corporate debt.2 In a world where only 11% of fixed income yields over 3%, that’s very attractive for investors.3

Seeking alpha in EMD

Finally, EM debt is also somewhere to look for alpha, and exposure to economic growth. In the corporate bond space in particular, we are able to find plenty of issuers that have healthy balance sheets and reasonable leverage, with opportunities to grow, and that yield well in excess of what is available in developed markets. From an ESG perspective, both EMD investors and issuers are becoming much more aware of the standards they need to meet to attract capital, which is another positive development.

 

On a regional basis, our most significant overweight is to Latin America, where we see bottom-up opportunities in names exposed to higher commodity and energy prices, and to the US as the leader of global growth. We are also overweight Africa, where we like the fundamentals of select sovereign issuers. Our most significant underweight is in Asia, where liquidity is tighter, and the post-pandemic recovery has mostly already happened. One of the benefits of investing across the whole of EMD rather than just focusing on Asian high yield is we don’t have to have a concentrated exposure to China; recent volatility in Huarong showed the benefits of this diversification.

 

While it may not have been the start to the year that everyone expected in EMD, if you look under the cover, you see an asset class that is behaving much more like developed markets than it used to from a risk perspective, but, from a return perspective, the higher yields and access to growth and alpha are much more attractive.

1 Source: Bloomberg. Year to date drawdown of JPM EMBI, CEMBI High Grade and CEMBI High Yield indices, 11 May 2021
2 Source: Bloomberg, 11 May 2021
3 Source: Bloomberg, 7 May 2021

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