Fixed Income Boutique

Swim against the emerging markets local bond crowd

| Read | 5 min

A high-conviction approach in emerging market local bonds means you often swim against a crowd that blindly follows an inappropriate index. This can make you feel lonely at times, but the longer you resist the market’s groupthink, the better for the investor.

Our approach is based on high conviction. When you hear the term “high conviction”, like many buzzwords, it can mean a lot of things and also, it can mean nothing. For me, the term has real meaning; it underlines how I aim to take advantage of the inefficiencies that I find in the emerging markets local currency universe.

The emerging investment universe consists of, give or take, 90 countries spread across the globe, of which around 50 have an investable local-debt market. It’s very difficult for any team, even a bigger one, to believe they can constantly analyze and be on top of everything within that universe.

For example, we do not invest in a country because it's a big country, nor do we invest because everybody else is there. We invest only once we have a strong opinion and see a promising opportunity. Therefore, we often think twice before buying into a country, regardless of what “the market” says.

To make this point really clear, for many other managers, their “neutral” position is based on the benchmark – they have a “neutral” weight when they have the equivalent amount of an underlying security to the benchmark’s weight. For us, neutral is zero. This is a very important point. It is not a GDP-weighted portfolio. It's not a benchmark-weighted portfolio. It's a conviction-weighted portfolio, and the weight is zero when I have zero conviction.

I view the emerging debt markets as inefficient. These inefficiencies create opportunities for an active manager. In my area, local currency bonds (debt denominated in the currency of the bond’s issuer), the inefficiencies present are mainly to do with structural, constraint-driven and governance inefficiencies. By identifying and analyzing these inefficiencies I hope to find opportunities that will deliver long-term performance for my investors.

What’s the use of a “benchmark-generated conviction”?

Let me give a clear example of constraint driven inefficiencies. Passive investment vehicles such as ETFs have an automatic conviction, as their remit is to replicate an underlying index and its performance as much as possible. In emerging markets debt, this has produced a strong skew. The reason is that the whole universe is represented by a couple of benchmarks – JP Morgan’s and Bloomberg Barclays’. They contain a relatively small number of countries, so they are not truly representative of the local currency debt universe, and also, they have a skew towards the commodity producers.

That’s why you see a very high correlation between countries in the benchmarks that are sometimes very different in terms of their economic model and where they are in the economic cycle. This is the case for Turkey and Mexico, for instance, where the correlation is high because the same people, trade them at the same time, for the same reason.

Therefore, if you go beyond the benchmarks, investing in non-benchmark countries, you have access to different risk factors. For example, for historic reasons, you have a lot of commodity producers in the benchmarks: oil and gas with Russia and metals with South Africa. Actually, almost two-thirds of the benchmarks have one or several commodities as risk factors, but at the same time, there are numerous countries that are not in the benchmarks and are commodity importers, so when you want to diversify your exposure to economic models and away from commodities, it is very convenient – even essential – to go beyond the benchmark. The classic diversification will only make sure you have a little bit of Asia, Latin America, Africa, Middle East and some emerging Europe – we think in a different way. The bottom line for us is that we end up with a portfolio that is diversified geographically, but that is not our starting point.

So, according to our macro views, we will balance the portfolio to make sure that our exposures to the underlying economic models are consistent with our views (e.g. commodities, global trade dynamics etc.). For example, maybe we want to be extremely cautious about oil producers – or we want more exposure to agriculture or countries like South Korea that live off their import/export manufacturing model. That is our way of diversifying the portfolio, and it will end up in something probably well balanced from a geographical perspective, but not driven by geography.

Portfolio Construction…. diversification across “business models”

Each country’s major export


Source: Observatory of Economic Complexity

Sustainability wins the race

Sustainability, perhaps surprising to many, is an important driver of long-term returns. When we speak about sustainability we are specifically looking at the governance bit of ESG. It's clear to us that the more a country strives to improve governance sustainability (the strength of its institutions, more freedom and democracy in the system etc.), it will eventually present investors with more sustainable economic growth (see chart 2). This is what happened in North America, Japan and Western Europe. So, the whole point is to spot and pick those countries starting off at poor or average levels, but taking active action in the right direction.

In addition to providing returns, when a country improves its sustainability metrics, it will probably result in avoiding drawdowns and increased volatility. This is due to the improving predictability and stability of the country.

Sustainable countries have better and more stable credit ratings

Development of credit ratings of 110 countries*

Countries rated sustainable have on average better credit ratings than non-sustainable countries.



Since 2007, countries rated sustainable have been able to keep their credit ratings constant, while non-sustainable countries have had to accept significant downgrades.



*Development of the equally-weighted credit ratings of the government bonds rated as sustainable in relation to the government bonds rated as non-sustainable; taking into account all countries that have a long-term credit rating in a foreign currency over the full time period at least at one of the three major rating agencies Standard & Poor's, Moody's and Fitch; Past performance is not a guide to current or future performance. Source: Vontobel Asset Management, as of 31.12.2017

Active investing for long-term returns

The emerging market local-currency is a broad investment universe, which is skewed towards the bigger economies by a few key benchmark indices. As many investors follow the benchmark, this creates inefficiencies that active managers can exploit. By being benchmark agnostic and investing with high conviction, across business models, and in countries that are on a sustainable path, investors can enjoy long-term returns from emerging market local-currency bonds.

Portfolio Manager track record: Significant outperformance vs the peer group average


Source: Citywire (as of 29.12.2017). Disclaimer: Net performances indicated. Past performance is no guide to current or future performance. Performance data does not take account of commission or costs charged when units are issued or redeemed.