Has Emerging Market Debt Entered the Mainstream?
Bonds are still the mainstay of millions of portfolios worldwide, notably insurance pools, institutions, and target-date retirement funds.
But current low and negative bond yields have given asset allocators schooled in traditional modern portfolio theory (MPT) a novel contemporary dilemma.
Conventionally, bonds secure their place in a diversified portfolio by earning uncorrelated returns guaranteed by the credit of an issuer such as a sovereign government (notwithstanding that the overall debt level of many leading sovereigns, adjusted for their pension, welfare and health care obligations, is somewhat concerning).
With yields so low, or nonexistent, are investors supposed to accept that the portfolio risk–dampening attributes of bonds are now inverted? In other words, if we assume interest rates normalize, bond returns are henceforth more likely to fall in real terms and amplify portfolio risk. Should investors instead look to higher yielding bonds for capital growth, perhaps accepting additional risks of exotic derivative-based overlay strategies to enhance tiny bond yields?
Many have elected to chase nominal yield ever further up the risk spectrum, even considering emerging market debt. So against this extraordinary backdrop, has the once adventurous world of emerging market debt finally entered the mainstream?
Speaking at the 69th CFA Institute Annual Conference, GMO’s Tina Vandersteel, CFA, said that emerging market debt is attractively priced, particularly local currency debt, at current relative levels. Vandersteel believes opportunities to outperform are real, especially from a bottom-up perspective, despite challenges created by declining liquidity.
The question-and-answer session that followed her talk is reproduced below.
A full written version of this presentation is also available in the CFA Institute Conference Proceedings Quarterly.
Audience Member: How can an investor structure a strategic and tactical investment program in both local and hard currency debt?
Tina Vandersteel, CFA: I believe in strategic allocations given the transaction costs of entering/exiting the asset class. Given rising bid-offers on the underlying bonds, we currently charge 75 bps in and out of our funds. This covers transaction costs and also discourages people from being tactical. Those seeking to time the asset class tactically using ETFs [exchange-traded funds] should pay attention to the swings in ETF premium/discounts, which themselves reflect underlying market liquidity to a certain extent.
Where are you finding value now?
From a top-down perspective, which is not our specialty, the cheapest countries are Russia and certain Central American countries, such as Belize and Costa Rica. Russia is not issuing dollar debt anymore, and the currency is cheap in Russia. Countries like Belize and Costa Rica actually benefit from lower oil prices and have pretty high spreads. Slovenia is probably the most overvalued in our universe.
Do you hedge local currency debt in your strategies?
At the aggregative level, not much because that amounts to beta timing. Practically speaking, we run a beta one program. Our currency alpha program overweights some currencies and underweights others, including currencies not in the benchmark, so at any given time, some of the benchmark currencies may be “hedged” in that regard.
Would you encourage investors to choose a manager who has a very broad universe and goes outside the benchmark, or is the benchmark very inclusive now?
GMO takes different roles in hard currency and local currency. In hard currency, the benchmark has caught up to active managers. A lot of countries formerly outside the benchmark — Mozambique, Tanzania, Senegal, and such — are now in it.
But for local currency, the benchmark is very small — only 15 countries. We have the same opportunity set for both strategies. The key for us is to identify a manager who understands the implications of doing something outside the benchmark. For example, I believe that going for more currencies is better because each one typically represents a smaller active risk.
Please discuss the current conditions for investing in China vis à vis the benchmarks.
From an alpha perspective, we have not investigated any of the EMBIG issuers because we can sell 10 year credit default swaps on sovereign China for about 175, and no corporate issuers pay that spread. Furthermore, very few dollar sovereign Chinese bonds exist. Besides, what credit spread can I get for holding sovereign China? If I take onshore (CNY) and offshore (CNH) renminbi debt and swap it back into dollar terms, unless it is a really dodgy issue or on its way to default, it does not pay enough to warrant consideration.
Please discuss Argentina’s re-emergence in the market.
Argentina’s new economic team has taken an entirely different approach to global debt markets from the preceding one under [Cristina Fernández de] Kirchner. Kirchner took a hard line with creditors, unprecedented in the history of sovereign debt workouts, which effectively locked them out of the capital markets for more than a decade. Finally, the citizenry elected a new president with a mandate for change, and things have changed quickly. When the [Mauricio] Macri administration came in, the economic team was able to explain to congress and the people how Kirchner’s stance was harming Argentina. Quickly, they were able to come to a settlement with the holdouts that allowed them to return to international capital markets.
How do you reconcile perceived lower cash fixed-income liquidity with fixed income ETF liquidity?
The ETF providers, such as BlackRock, make a good argument for the case that an ETF is a more efficient vehicle for institutional investment managers who are constrained from using derivatives. An ETF offers a way to equitize cash in an effort to time the asset class. The questions center on the costs of so doing, where management fees are high (relative to active managers) and the loss of asset custody a potential risk.
Is credit improving, stable, or declining with low nominal GDP growth?
I cannot offer a definitive answer. The average debt-to-GDP ratio for countries in EMBIG is probably fairly stable, especially if I consider countries that default and lower their debt to GDP the old-fashioned way. I believe it is likely that the rating agencies, because of current low interest rates, are not downgrading some countries as much as they might have otherwise because debt service is still very low. Debt GDP may be growing a little bit but not debt service.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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