Emerging market bonds: no longer a homogenous asset class
We believe that emerging market bonds can no longer be viewed as a homogeneous asset class in which all component parts respond unanimously to the same stimuli. Rather, it should be viewed as a multi-asset class suite comprising
- Local bonds
- Sovereign credit
- Corporate credit.
Each of these should be considered as a separate risk asset class with its own dynamics and drivers. We expect the large and diverse EMFI asset class to continue to evolve further and have a different make-up than it does currently.
While not all investors may have scope to access all four sources of alpha, we are seeing an increasing number, even at the institutional level, delegating the asset allocation decisions on how their portfolio of EMFI assets is made up.
Often, the first key decision following discussion with managers is to allow both hard and local currency emerging market bonds within the same portfolio. Further high-level management decisions drive aggregate duration and currency risks, the composition between local and hard currency exposures, relative value between investment-grade and high-yield, and corporate versus government bonds.
Diversified alpha sources in emerging market bonds
As said, the different EMFI asset types are driven by distinct factors.
- For hard currency debt (sovereign and corporate issues denominated in USD and EUR), the consideration is the potential compression of spreads over US Treasuries.
- For local currency debt, we consider yields driven by local inflation and monetary policy dynamics.
- Currencies, in contrast, are driven by technicals (capital flows) above all else and should be treated with a trading lens.
We believe these asset universes should each be treated with
- Its own value identification process
- Different holding periods and investment horizons
- Unique trading conventions, liquidity characteristics and execution desks.
By doing so, we can potentially enhance our alpha sources by diversifying among alpha processes and multiplying the number of alpha opportunities at our disposal.
Diversifying between hard and local currency emerging market bonds
Investors in EM bonds often consider hard currency spreads and local currency yields in the same breath; but each behaves differently over time. For spread, performance volatility is crucial and has much to do with liquidity and macroeconomic cycles rather than individual country risk.
In contrast, yields respond to local central bank cycles and domestic monetary policy. During the 2003-2008 global growth cycle, the pro-inflationary environment caused a gradual rise of yields in local currency even as spreads were falling. Coming out of the Global Financial Crisis, global disinflation pressured EM local yields lower, although spreads were range-bound owing to suppressed volatility.
It might seem surprising that, over the entire cycle, the correlation between spreads and yields is in fact very low, at just 29%. Highlighted in the green boxes in Exhibit 1 below, we show the periods during which the correlations between spreads and rates were negative; as an investor, you would have an entirely different investment experience during these periods depending on whether your allocation was biased towards hard currency or local currency debt. These represent distinct and uncorrelated alpha streams for investors considering the full range of emerging market bonds.
Exhibit 1: EMD hard currency spread versus local currency yield
Source: BNP Paribas Asset Management, Bloomberg, as of October 2017, for more information on the JP Morgan Emerging Markets Bond Index (EMBI) click here.
The same diversification holds across EMFI asset types. Currencies are highly correlated with each other and largely driven by the US dollar, commodities prices and global growth dynamics. These have little overlap or interaction across the cycle with spreads or yields. The corollary in corporate bonds are the drivers of corporate sector trends and corporate default rates, which have a closer relation with global corporate bond spreads than with other EM asset classes.
We emphasise the diversification of these elements by building strategies that can benefit from all four alpha sources:
- Local currency emerging market bonds only draw on opportunities in local currency denominated bonds and foreign exchange positioning
- While hard currency denominated EM bonds draw only on managing sovereign and corporate risk premia
- Blended and total return EMFI strategies can however directly exploit all four types of investment activity.
This scope and range of opportunities enhances the total alpha power of our blended portfolios, potentially simultaneously compounding excess return and diversifying sources of outperformance.
Total return is the optimal solution for emerging market bonds
What happens if we combine both hard and local currency universes into a portfolio with a superior risk/reward profile? Overall, the composition of the two returns results in an arithmetical mean return with lower volatility.
The independent responses of local and hard currency debt to their respective drivers result in two very different risk/reward profiles.
Hard currency bonds have historically achieved a return of around 8% annually with a volatility of 10%, whereas for local currency debt, the risk/return profile is inferior due to years of large drawdowns: returns of around 6% per year with a volatility higher than that of its USD bond counterparts.
This raises the question as to why you might invest in local currency EMFI. The answer lies in its cyclicality and the fact that currencies do not fall in an efficient frontier; currencies can be high carry and low volatility at the same time – or low carry and high volatility. Over a multi-year period, currencies will either rise cyclically with a macroeconomic factor or depreciate in line with a macroeconomic factor.
Exhibit 2: EMFI asset classes: return versus risk since 2003
Source: BNP Paribas Asset Management, JP Morgan, as of May 2017
From recent cycles, investors have learned the hard way about the differences between local currency and hard currency debt, between investment-grade and high-yield EM bonds, and between sovereign and corporate issuers.
In a total return construct, however, the asset allocation decision is taken by the manager, who can provide the full spectrum of EMFI asset class exposures in proportion to their expected relative return over each review period. Not only are each of the different alphas considered as different asset classes, the narratives for investments in blended portfolios can actually be very different at times, resulting in overweight/underweight positions in these different elements of EMFI.
To reach this decision, we have an asset allocation meeting every six weeks during which we systematically work through the same factors that affect emerging market bonds, beginning with the US Federal Reserve and US Treasuries, credit spreads and the credit curve for hard currency bonds, and EM currencies, rates and inflation for local currency debt.
Current view: expect local currency outperformance
Our current view is to recommend local currency outperformance. This is a cyclical call and one that we expect to continue for the next two to three years. Many EM central banks can cut interest rates further and some others will join the lower rate theme, potentially generating double-digit returns in local emerging market bonds.
In contrast, with spread compression exhausted and US interest rates rising, we expect negative returns to duration in hard currency bonds, restraining overall returns relative to 2017.
We believe clients will value this added insight and layer of investment acumen, having concluded that the manager is closest to the asset allocation decision and best placed to provide that service as part of the active management of investments.