EMD was at the top of most investor surveys heading into 2021, but we have seen negative performance from the asset class so far this year. However, this volatility has been driven entirely by US interest rates, and the fundamental tailwinds behind EMD are still there, says Alejandro Arevalo, Head of EMD. The asset class looks very attractive compared to developed market fixed income, including high yield. Alejandro and his team believe it’s a great opportunity to make an allocation for the long term.
EMD performance has been driven by interest rates alone
At the turn of the year, the consensus was that 2021 was going to be a great year for emerging market debt (EMD). But it hasn’t turned out like that so far, with the asset class losing money in each of the first two months of the year. It’s important to recognise, however, that these losses have been caused entirely by rising US interest rates. EMD spreads1 have narrowed over this period. Higher quality, longer duration bonds have underperformed because their returns are more dependent on US rates. High yield EM credit has been the place to be, while investment grade sovereign bonds have not.
Plenty of reasons to remain bullish on EMD
The list of tailwinds that made the market so bullish at the start of the year hasn’t changed – in fact, the case is even stronger. Global economic momentum remains robust. Fiscal policy is still exceptionally loose, and the latest US fiscal package is larger than originally expected. Reflation is good for EM, particularly commodity producers. The importance of Covid-19 vaccines is both greater and different for EMD versus developed countries: greater because EM countries don’t have the same resources to support economies through a pandemic; and different because access to vaccines will come later than in developed markets. These factors all point to strong growth for EM economies in 2021, 2022 and beyond.
Higher interest rates and a strong US dollar aren’t the problems they used to be
In the past, emerging markets were much more vulnerable to external stresses than they are now, which helps explain why the move in rates hasn’t hurt EMD spreads. On the whole, emerging markets show much more macro prudence than they used to, with generally healthy current account balances and FX reserves. Furthermore, EM countries have learned from the past and reduced exposure to rising US yields and external currencies. Relative to developed market fixed income, EMD is now much more resilient to rising interest rates than many suppose.
EMD looks more attractive than other fixed income
With 90% of fixed income yielding under 3%, yields of between 4.5% and 7% are enticing, especially when adjusted for risk. EM credit, in particular, delivers a higher yield per unit of risk than developed market credit. Why? In our view, this is simply because EM companies have to pay a premium because of their EM label, which often isn’t justified.
Investors often compare EMD to US high yield, though EMD is actually a higher quality asset class: it has lower leverage, less concentration in the energy sector, and fewer ‘C’ rated names. Historically, it has delivered a higher Sharpe ratio and much lower volatility. In addition, EMD is cheaper on a spread basis than US high yield. This hasn’t always been the case, and US high yield spreads have been narrower than EMD since central banks started intervening in developed bond markets nearly a decade ago. It follows that EMD now has less to lose from rising rates and tightening financial conditions. Recent volatility has only served to make buying EMD even more attractive today.
Selectiveness is key
We remain bullish on EMD – but not all EMD. Choosing the right areas of the market and the right credits is crucial. Understand top-down macro is important. For example, we have been overweight high yield to reduce exposure to US rates, which has been beneficial so far this year. Increasing our exposure to the Middle East has allowed us to benefit from rising oil prices. We have also been avoiding higher duration bonds, especially in sovereign debt.
We always focus on answering the following question: are we paid for the risk we take? If not, we will avoid an investment or sell a bond. A great example this year is Petrobras, where spread tightening meant we were no longer paid for the risk of potential political intervention, so we sold out of the position in the strategies. This meant we avoided the pain of the sell-off when the government announced it would intervene and replace the company’s CEO.
Invest for the long term
We advocate this risk-focused, “through the cycle” approach because investors’ approach to EMD has changed. While it was once at the periphery of their portfolios, for investors to dip their toes in for the good times and try to get out before they ended, those days are gone. The quality of EMD has increased so much, we believe it is worthy of a long-term allocation, and investors need the additional yield on a permanent basis. It’s important to be able to perform whatever the weather, and not just when the times are good.
We believe the volatility we have seen in EMD this year has nothing to do with asset class fundamentals: it’s simply a US rate story. The asset class has huge tailwinds behind it, it is much more resilient than it used to be, and we are expecting strong asset class performance over the longer term. We think it’s a great time to add a structural allocation to EMD in portfolios to access yield and capital growth – but a risk-focused approach is required.
1EMD spreads: The additional return an EM bond gets on top of the US treasury yield
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