Who Are The Best Investment Managers for Emerging Market Debt?

EMD searches on RFPnetworks are amongst the top 5 asset classes by funded AuM. With so many managers globally, finding the best EMD managers requires a huge amount of data, which is one of our specialties. But equally challenging is deciding in which segment of the EMD market to invest.

EMD research inside RFPnetworks therefore tends to receive a relatively large proportion of our daily traffic. And currently, there seems to be a lot of interest in Hard Currency EMD. Which is interesting given there is a lot of information to digest from the YTD Sep 2022 numbers:

Both hard and local currency bonds have had similar outflows. But in September itself, outflows from hard currency bonds were approximately double that of local currency bonds.

Hard currency bond returns are approximately 5% lower than local currency bonds, and have fallen in line with the S&P 500, at a time when the VIX has breached 30 indicating significant market stress.

In contrast, the 5 year return numbers show an outperformance of hard currency bonds over local currency of around 600 basis points. And comparing hard and local currency drawdowns during market stress periods (e.g. the taper tantrum of May 2013), hard currency benchmarks exhibited a trough that was shallower and narrower than that of local currency benchmarks.

The longer term numbers may be a result of lower liquidity (and higher trading costs) for hard currency bonds - ultimately investors want to get paid for the risks they take. But there are many other factors that investors are researching:

The differences in the underlying universes is significant. Hard currency bonds are issued by approximately 70 countries. Local currency bonds by around 20 (of which 10 account for 90% of the main index). So whilst the more widely accepted local currency bond market is almost 10 times larger than the hard currency bond market, there is more diversification to be found in the hard currency market.

That said, 50% of the hard currency universe is below investment grade, compared to 25% for the local currency issuer universe. But with 60% of EM CCC bonds now trading below $40, there could be some interesting hard currency restructuring stories unravelling.

These are but a few of the research topics we see getting lots of traffic today. ESG for sovereign EMD issuers has also become important. As has the impact on EM bonds of the strength of the USD, the price of commodities, supply chain fluidity in light of COVID lockdowns, the opening of the world to tourists, and elevated geo-political risks.

EMD is a fascinating asset class, but still only represents 20% of global fixed income markets. But given the higher yields versus developed markets, it is always on the radar as a diversifier and growth component for fixed income portfolios. And currently EMD Hard Currency seems to be attracting all the attention.

The default allocation to EMD tends towards local currency bonds. The market is larger than hard currency bonds, more liquid, and of higher quality. But are you getting paid for your risk today, and if so, where is the outperformance of local currency bonds coming from?

With 10 year treasury yields breaking 4% for the first time since 2007, and EM Sovereign Bond prices falling to levels not seen in 20 years, investors are taking another look at EM bond markets. The fixed income feed inside RFPnetworks was dominated last week by new papers dissecting the universe: The risks, the drivers of performance, and the outlook for EM Fixed Income markets versus developed markets.

Emerging Market Debt, like the entire fixed income asset class, has had a tough start to 2022.

Even hard currency bonds, as represented by the JP Morgan EMBI Global Diversified Index, have seen YTD returns not experienced since 1995. With 1Q22 completing four consecutive negative quarters - an occurrence which has only happened 3 times since 1993.

Looking further across the EMD spectrum, YTD performance for emerging market local sovereign bonds, investment grade and high yield corporate credit have all registered double digit negative returns.

With such results, it is of no surprise that YTD outflows for both local and hard currency bonds are now around the USD mid-teen billions.

The good news is twofold:

- EM Bond Yields are reaching levels where institutional investors are consider re-entering the market. Even frontier country bonds, with 50-60% higher than their hard and local currency emerging market counterparts, are gaining interest.

- And secondly, with the main contributor to the negative performance YTD being the interest rate differential between EM countries and the US. But, as many EM Central Banks pro-actively accelerate their interest rate hikes, real interest rate differentials may soon make EM local markets relatively attractive.

Yet many questions on the outlook for emerging market debt remain. Country specific risks remain elevated. As do lingering COVID concerns and geopolitical risks. And the cheapness of EM currencies is sensitive to the strength of the USD, which is being propelled by a hawkish FED and a risk-off safe-haven attraction.

But as always with Emerging Markets, there will be winners and losers. Selective EM economies and corporates are fundamentally strong and benefiting from rising commodity prices. Whereas for others, the post-COVID normalisation path is still unclear.

Like CCC securities in the corporate high yield space, distressed Emerging Market Sovereign debt is often an overlooked segment of the asset class. But possibly for the wrong reasons.

The simplistic view is that buying distressed debt has the risk of default that results in the investor receiving zero. In practice, between default and zero lies the restructuring story. Which whilst often anticipated and complex, pairs a risk with a potentially high reward.

Factor in haircut calculus, historical recovery values averaging 50%, and deep discount purchases from forced sellers, the ability to generate double digit returns by experienced distressed debt asset managers has not gone unnoticed by the professional investor community. Nor have the opportunities that exist in today's Emerging Market Debt environment.

1Q22 saw sizeable net outflows from across the Emerging Market Debt spectrum. Yet of the -$14.1 billion net outflow, during the quarter only 16% (-$2.2 billion) streamed out of local emerging market debt markets.

Digging deeper, what was also noticeable was that whilst many markets suffered as a result of the impact of the Russia-Ukraine crisis, including CEEMEA, China and much of Asia. Both the commodity beneficiaries of ASEAN and LATAM were the clear winners.

For investors with Global EMD asset managers, the question of shifting to a more regional approach to the asset class is starting to gain attention.

This is the big theme Emerging Market Debt investors are discussing with investment mangers. No surprises that there is lots of research and live updates on the impact of the Russia-Ukraine crisis on EM bond investors inside RFPnetworks.