Emerging Markets Bonds
The Vontobel Fixed Income Boutique’s emerging market debt franchise celebrates its tenth anniversary this year. To mark this key milestone, our team leaders weigh on the evolution of emerging market bonds in the last decade, explain the advantages of active investing, and provide their views on what lies ahead as more investors flock back to this asset class.
Simon Lue-Fong, Head of Fixed Income Boutique: As we hit this impressive milestone, what has stayed the same in a world that is constantly changing?
Luc D’hooge, Head of Emerging Markets Bonds: Emerging market sovereign debt remains a deep, diversified, mostly liquid asset class that continues to be under-represented in many investors’ portfolios. It’s still seen as tactical rather than a strategic pillar. During this past decade, we’ve continued to see segmentation, i.e., strong market distortions that limit the free flow of capital. These distortions may be geographical, or the result of rating/currency constraints. For example, when investors resort to exchange-traded funds (ETFs) they end up buying or selling the same bond at the same time for the same reason as they try to replicate an index. This technical impact weighs on the relative valuation between securities, creating an ideal landscape for an active manager.
Recently, the 10-year Ivory Coast euro-denominated bond was delivering more than 50 percent excess spread compared with its equivalent bond issued in US dollars, which even has the disadvantage of being callable. Indeed, while the latter is included in the reference index – and thus bought by ETF managers – the former is not. In the last decade, active management that focuses on exploiting spread distortions and uses a bottom-up value approach has been able to generate higher alpha and/or higher income for investors than the index.
Simon Lue-Fong: So how has emerging market fixed income changed in the last 10 years?
Wouter van Overfelt, Head of Emerging Markets Corporates: Policymakers have steered away from austerity – the fiscal policy that followed the Great Financial Crisis – and shifted toward monetary policy with a focus on lower rates. There is a debate whether lower rates are structural or not, but the end-result of quantitative easing was to benefit emerging markets a lot, especially hard-currency emerging markets. Compared with a decade ago, many more countries are now included in the JP Morgan Emerging Markets Bond Index (the reference index for emerging market corporates), especially frontier countries that are at an earlier stage of market development. Emerging market corporates have developed as a separate asset class that is now larger in size than the sovereigns. At the same time, local currency bonds have not performed as well because the commodity “super-cycle” was no longer there as it was in the first decade of the 21st century.
Emerging market corporate bonds tend to be under-researched and under-arbitraged, leading to plenty of segmentation and thus relative-value opportunities. These provide the ideal hunting ground for high-conviction active managers to generate alpha and higher income as there will always be winners and losers. “Buying the market” looks like a poor option in such an inefficient market. On top of this, there will always be an “event” happening somewhere in the emerging market corporate space. This is ideal if you want to generate alpha and diversify returns.
Luc D’hooge: The emerging market sovereign asset class has been expanding, too. The market capitalization has doubled in the past ten years, but at a much slower pace than emerging market corporates. In terms of evolution, we have seen a “barbell effect”. While the average rating of the index remains the same as ten years ago, we have seen strong growth on both sides of the quality spectrum: multiple high-yield frontier markets in Africa and Asia entered the index and many high-quality Gulf countries have grown in size. The latter were so important that the average quality of the investment-grade subindex changed considerably.
The local-currency emerging market has grown, too, thanks to the arrival of new entrants as well existing issuers expanding and “professionalizing” their local markets. This has a positive effect on both external debt and a well-developed local market. The extra financing source can act as a pressure valve at times of stress.
Simon Lue-Fong: Who were the winners over this period?
Wouter van Overfelt: In terms of beta performance in the hard-currency space, emerging market sovereigns had the upper hand in the period between 2013 until the end of that decade. It was a period marked by high tactical inflows as investors sought high yield in a low- or negative-yield environment in developed markets. Emerging market corporate bonds have performed relatively better since the start of this decade as investors didn't want duration and probably less credit risk in a period of strong volatility (i.e. Covid, cost-of-living crisis). In fact, emerging market sovereign spreads underperformed relative to emerging market corporates as most of flows into sovereigns that had marked the 2010s began to recede, especially last year.
Simon Lue-Fong: Another major evolution in the decade has been the growing importance of environmental, social, and governance (ESG) criteria. Does taking an ESG approach make sense when investing in emerging market bonds?
Wouter van Overfelt: We talk a lot about climate change. At the very least, if you want to tackle the climate problem, emerging markets must get support given their importance in manufacturing, need for energy transition, and social development. So investing into the right assets in emerging markets is the only way to tackle the climate problem on a global scale. And probably many other problems as well.
In emerging markets, ESG considerations help companies protect their environment, such as in Chile, where the government plans to close half of its coal-fired power plants by 2025 – 15 years ahead of a deadline to eliminate fossil fuel from its power mix. I think that's a strong example of how investors can make real changes today. That’s why I see growing support for ESG investing in emerging market bonds. It's in its infancy, but it's thriving and positive for the asset class.
Simon Lue-Fong: Going forward, what do you think the main market themes will be?
Luc D’hooge: In terms of beta, I’m optimistic on emerging market assets. I believe the pain trade is getting very uncomfortable for many investors who’ve sat on cash and have watched a strong first-half rally from the sidelines. Indeed, emerging market hard currency bonds have seen negative flows again this year despite stellar returns, as investors often buy past performance. With US inflation peaking and falling interest-rate volatility the flows could change. In that environment, the higher duration of sovereigns – a hurdle in the past few years – could become very popular again.
With US interest rates easing, there could be less support for the US dollar. This in turn could support emerging market local currency bonds, especially as investors seek to lock in the higher real yields that emerging markets offer. This is because emerging market central banks were much quicker to react to inflation.
Wouter van Overfelt: I also see multiple alpha opportunities as the market stays segmented. On top of that, active investing after a period of stress can help find attractive assets that the markets’ knee-jerk reaction has left undervalued. Indeed, I see a lot of dispersion in emerging market high yield in both sovereign and corporate segments, where there will be winners and losers in the post cost-of-living-crisis era.
Simon Lue-Fong: I believe emerging market fundamentals are stronger and better for growth than developed markets. Indeed, investors are telling us they are once again bullish on emerging market fixed income. In our latest survey of more than 200 institutional investors , 75 percent said they are likely to up their exposure to emerging market bonds over the next two years.
Do you have any thoughts in terms of investment strategies?
Luc D’hooge: Probably the most prominent shift seen in the past few months is the revival of the local currency market after a decade in the wilderness. Investors are now coming back either directly through local currency and/or through blend strategies for those preferring a broad exposure to emerging market fixed income. This has also been confirmed in the survey. Investors have also returned to emerging market sovereign debt, either through the traditional “flagship” strategy or its sustainable version. They are attracted by the higher duration and spread in this market as well as the benefits of active ESG investing.
Wouter van Overfelt: In the immediate future we will need to see the impact of the higher rates on emerging markets and the ability to refinance. That means that investors will probably prefer investment grade and higher-quality high yield first. I believe we will see quite a few defaults in the coming years, and it will be crucial to enter only after the risk has been priced in.
Several institutional investors who have ratings constraints have moved into the emerging market investment-grade space. These bonds have delivered sizeable returns, indeed more than double the returns of their developed markets counterparts since the start of the year. Such a major shift shows how both emerging market fixed income and investors’ objectives have evolved. It would have been hard to imagine a pure, diversified investment-grade fund in emerging markets a decade ago.
Simon Lue-Fong: As investors conclude that rates are not going to stay high forever, they will realize that invest-and-forget strategies won’t work anymore given the level of uncertainty on the macroeconomic front. That’s when real active management in emerging market fixed income is going to be highly sought after. And the opportunity across hard and local currency, through blend or pure solutions, has rarely been so attractive.
Important Information: Past performance is not an indication of future results. Investments referenced herein for illustrative purposes only to elaborate on the subject matter under discussion. Such information should not be deemed a recommendation to purchase, hold or sell the same or similar. No assumption should be made as to the profitability or performance of any security associated with them. Neither asset allocation nor diversification assure a profit or protect against loss in declining markets.
Any projections or forecasts herein are based on a variety of estimates and assumptions. There can be no assurance that assumptions regarding future financial performance of countries, markets and/or investments will prove accurate, and actual results may differ materially. The inclusion of forecasts should not be regarded as an indication that Vontobel considers such to be reliable predictors of future events, and they should not be relied upon as such. Environmental, social and governance (“ESG”) investing and criteria employed may be subjective in nature. The considerations assessed as part of ESG processes may vary across types of investments and issuers and not every factor may be identified or considered for all investments. Information used to evaluate ESG components may vary across providers and issuers as ESG is not a uniformly defined characteristic. ESG investing may forego market opportunities available to strategies which do not utilize such criteria. There is no guarantee the criteria and techniques employed will be successful. Unless otherwise stated within the strategy's investment objective, information herein does not imply that the Vontobel strategy has an ESG-aligned investment objective, but rather describes how ESG criteria and factors may be considered as part of the overall investment process.