Beyond the core

May 4, 2018

Institutional investors traditionally have depended on core domestic bonds for income and on emerging market debt (EMD) for tactical opportunities. This may have served them well in the past, but we believe a changing investment environment is prompting some to reconsider EMD as a potential source of income. Its higher coupons also come with potentially attractive diversification and alpha opportunities.

However, following a two-year rally in EMD, we believe investors need to be more discerning. A rising interest rate environment will impact individual emerging markets differently. Uncertainties over the direction of the U.S. dollar, global trade policies and a busy emerging markets election calendar may help to usher in higher volatility, and higher dispersion.  

Sergio Trigo Paz, Head of Emerging Markets Fixed Income, shares his views on the evolution of EMD investing, and how investors may be able to optimize its income potential.

How are investors approaching EMD today?

Having spoken to investors who have been in emerging markets for more than 15 years, one of the main changes is that previously they were only allocating opportunistically. Now, they’re moving closer to a structural approach. So the discussions that I’m having today typically revolve around the appropriate size of the structural allocation, and from there, how to tactically take advantage of the different sub-asset classes that emerging markets offer-hard and local currency government bonds, and corporate debt across the duration spectrum. See the chart below

Growing assets

Outstanding emerging market debt, by type

Sergio graph

Source: Bank of America Merrill Lynch, December 2016.

The move from tactical to structural has led some investors to shift their investment horizon from about one year to maybe five years, and this allows them to be more comfortable with short-term risk events. And by the way, I would note that nowadays most of these events are coming from developed markets and feeding into emerging markets, rather than emanating, and spreading, within EM—that type of contagion was more of a1990s phenomenon. 

What happened in the ‘90s and how have EMD markets evolved since?

When I started trading EMD in the ‘90s, the market was driven mainly by event traders targeting equity-like outcomes. And contagion was very high because there were fewer emerging markets in the investment universe, and very few long-term EM investors.

Then we entered the 2000s. China joined the World Trade Organization, expanding trade and investments among its trading partners and helping to trigger a bull market for EM fundamentals for the following 10 years. However, I think the decisive moment for many institutional investors was the European sovereign debt crisis. Suddenly they were compelled to reduce their risk exposure in Europe, yet they already had enough allocated to the United States and Japan, and of course there were risk events happening there as well. So by necessity, they had to go to emerging markets. Since then, many investors have changed their attitudes toward emerging markets.

What risks should investors be aware of today?

I think that investors are aware of most of the issues, because they are actually developed market issues. Number one is convexity, which in developed markets has resulted in the high-duration, low-coupon investment environment that we’re in. With little cushion against rising rates, we believe any sell-off could trigger contagion to all fixed income, including EM.

The other major concern is the direction of the U.S. dollar. On the one hand, the Fed is normalizing monetary policy, which should strengthen the dollar. On the other hand, the U.S. Treasury will need to issue more debt to fund tax cuts and, potentially, fiscal stimulus programs, which will likely lead to a weaker dollar.

The tension between those two drivers is going to stay with us for some time. And this means higher volatility, and investors will need to ask for a higher risk premium to hold that volatility. As a result, we believe a global re-pricing may be underway. The question is whether a potential re-pricing is going to be a one-off situation or a grinding re-pricing that stretches over years across many asset classes.

What can investors do to mitigate the downside risks?

I think the answer lies in the investment process and in moving away from the classic emerging market approach. What that means is avoiding the countries that have a higher probability of negative risk events, so that you can reduce volatility from a bottom-up perspective. From a top-down perspective, you might say if we have contagion from global markets, then eventually we will exit that contagion period. So in theory, if your selection recovers, then this shouldn’t matter as much if you’re a long-term investor. In reality, however, it does matter, because there’s not much insulation for the portfolio during drawdowns.

The way that we attempt to address that issue is to combine a bottom-up asset allocation process with rigorous stress-testing of different scenarios. If a risk scenario arises or comes back, we can then be faster to de-risk in pursuit of a less volatile experience for our clients.

Can you give an example of how this process works in practice?

We performed a scenario analysis for the U.S. elections. We had two scenarios for a Trump victory—one with global risk aversion and the other with reflation—and one scenario predicting a Clinton victory. This allowed us to react to the sell-off as results came in on the night of the elections. As soon as Trump won Florida, we started to adjust our portfolio towards a Trump victory.

Performing that type of scenario analysis ahead of time and quantifying how much we could potentially lose makes my portfolio managers more aware of the risks in their portfolios. They are better prepared to manage those risks as events unfold, rather than addressing them in a panicked fashion. If you go into a b uilding and you know where the fire exit door is, you’re more likely to survive.

How do you manage the costs of allocating dynamically?

I believe that if you do your homework through scenario analysis, you have an idea beforehand about the most efficient ways to reduce risk at any given moment in time. You’re aware of the bid-offer spreads, transaction costs, position sizing and so on. And you de-risk at the portfolio level rather than asset by asset, because it’s more effective.

For example, if we have a hypothetical negative oil price shock and we’re holding bonds that are exposed to oil-producing countries we could de-risk a portion of the portfolio by going long the U.S. dollar and short the Russian ruble. This would allow us to absorb some of that initial shock and to avoid having to struggle to sell every single oil-linked bond.

How do you approach volatility in EMD?

The impact of volatility on emerging markets will depend on the source of that volatility. Volatility is not always a bad thing. If it’s built into a country’s policy, that’s something to be worried about. On the other hand, if volatility results from a gradual rise in interest rates because the economy is growing strongly—maybe that could be contained since emerging markets are positively correlated with growth. But if volatility is driven by expectations of more rapid tightening of monetary policy, and that leads to an equity sell-off, as we saw in February, then that is more complicated.

Another thing to keep in mind is that while emerging markets have historically experienced higher spikes in volatility, that higher volatility also means that they may be able to recover from sell-offs  more quickly  than other, less-volatile asset classes, including U.S. equities. So for investors willing and able to navigate through the volatility, the asset class may potentially provide a diversified source of income with additional alpha opportunities.

Sergio Trigo Paz
Head of Emerging Markets Fixed Income