Thirty years of EM debt: The growth of an asset class
Emerging markets (EM) fixed income investing has undergone a tremendous transformation in over three decades of existence. What began as a relatively small interbank market of loans to “less developed countries” has now evolved into an asset class that is here to stay. While EM debt has not yet reached mainstream status, the asset class continues to mature both in terms of breadth, credit diversity and market depth. For instance, the J.P. Morgan EMBI Global Index, one of the most broadly referenced benchmarks, includes 65 countries and issuers with credit ratings ranging from AA to CC. Moreover, the EM investor base has expanded beyond the traditional dedicated funds to include many crossover investors whose core mandates include high-yield and investment-grade credit.
The total EM debt stock has grown approximately 14% per annum over the past 15 years and currently represents about 16% of global debt. As of the end on 2015, total global EM debt outstanding was US$18.2 trillion. This figure includes not only sovereign issuance but also sovereign-related and corporate debt. While domestic markets (instruments denominated in local currency) represent the lion’s share of the EM universe, external debt (usually denominated in hard currency) has also grown significantly and is now slightly larger than the global high yield market with US$2.8 trillion outstanding. Regional composition is dominated by Asia, most notably China, followed by Latin America, while EEMEA—Eastern Europe, Middle East and Africa—is much smaller by comparison.
The clouds lift for EM fixed income
After a turbulent year and a half, from mid-2014 to February 2016, the strong performance of EM fixed income last year—particularly in 2Q16 and 3Q16—and so far in 20171 has drawn strong inflows into the asset class. Year-to-date, cumulative flows into EM debt stand at US$28 billion (compared to 2016 inflows of US$43 billion and 2015 outflows of -$14.4 billion), the majority of which have gone into hard currency funds.
There are several reasons for the renewed optimism around EM:
- Concerns about China’s ability to manage its short- to medium-term growth trajectory have largely subsided. To be sure, China remains front and centre to the rest of EM economies and one of the main medium term risks, in our view. But for now, this risk has taken the back seat.
- Stronger fundamentals across EM countries, driven by two main factors. First, EM economies have recovered from the sharp terms-of-trade downturn that followed the collapse of the commodity complex during the second half of 2014. Moreover, EM is benefitting from a synchronized cyclical upturn with developed markets, which has been in place since mid-2016. Second, EM funding requirements have declined markedly in recent years as current account balances and FX reserves as a share of GDP have improved more than external indebtedness.
- Fears about protectionist U.S. trade policies have waned as the Trump administration has toned down the rhetoric around this issue.
- The path of U.S. Treasury rates has become less concerning. As we argued in our previous North American Fixed Income Update, the window of opportunity for the Fed to raise rates is narrower than what the Committee and most observers believe. More recently, economic data point to a stall in the reflation cycle, sparking a rally in U.S. Treasuries.
- The technical backdrop for EM debt remains supportive as investors’ outsized reductions to EM exposure in prior years (2014-2015) led to an under allocation to EM. The importance of such technical support has been evident in recent risk episodes (namely Brexit and U.S. elections), during which EM fixed income showed remarkable resiliency.
Signature’s approach to EM fixed income investing
As mentioned above, investors have poured capital into EM assets searching for yield in a world with historically low interest rates and unprecedented liquidity, courtesy of years of quantitative easing by developed markets central banks. The problem (and the opportunity for long-term investors) lies in the fact that such an environment in which “a rising tide lifts all boats” often masks weak credit fundamentals and effectively becomes an implicit sponsorship of bad credits. In our view as long-term investors, given the volatility and heterogeneity of the asset class, the return of capital (i.e. avoiding defaults) is paramount and must be prioritized against seemingly attractive yields.
We believe that exposure to EM debt plays an important role within investors’ fixed income allocations, as a portfolio diversifier and an additional lever to harvest excess returns. It is important to keep in mind that EM economic and market cycles do not always coincide with those in developed markets, so investors would be well served by taking a medium term view, looking past short-term volatility and investing through the cycle. Only then can the return and diversification benefits of EM investing be reaped.
Our core EM positioning follows a fundamental strategy that utilizes forward-looking analysis of macroeconomic variables and other determinants of credit quality of the countries we invest in. We believe this approach, implemented over full market cycles, will allow us to identify opportunities for outperformance. Our EM portfolio construction philosophy draws from global and local insights to make top-down country allocation calls. In addition, our alpha generation strategy is complemented by bottom-up security selection through relative-value analysis. As part of our portfolio construction philosophy, we seek diversification across issuers and avoid concentrated bets due to idiosyncratic risks and liquidity challenges.
EM portfolio positioning
The following table provides a snapshot of the positioning in our EM portfolio, relative to the J.P. Morgan EMBI+ Index.2
We currently hold a modest duration underweight as a way to express caution around any potential changes in Fed rate expectations. However, the reflation cycle has stalled in recent weeks and inflation expectations have curbed down. If this trend were to consolidate, our duration underweight would be covered.
In terms of sovereign spread exposure, our underweight stance is related to a combination of what we view as fair valuations (especially, given strong spread compression year-to-date) and an underweight exposure to fragile credits. As valuations improve or we become constructive on some of these names, we will seek to cover the spread duration underweight. The following two examples can shed more light on how we think about setting our active positions. Argentina, which early last year concluded a decade-long debt restructuring process, has set out on the path of credit improvement. It will take time and there will be signposts to watch along the road but, in our view, the long-term trajectory is positive and we have therefore taken an overweight stance on the name. By contrast, the Philippines has enjoyed strong fundamentals for years and currently commands one of the tightest spreads among EM sovereigns, especially relative to similarly rated credits (in the BBB category). While we recognize the fundamental and technical strengths that are priced into these spreads, we view them as too expensive and have therefore taken an underweight stance on this credit.
The core of our yield curve positioning is concentrated in the 5-to 10-year sector of the curve which we believe offers a better risk-adjusted return over the cycle, given an attractive carry profile available in short maturities while maintaining the ability to take advantage of spread compression in slightly longer maturities (10-year sector). From time to time, opportunities arise to tactically extend duration either as the result of market dislocations or as a way to express a bullish outlook on a credit.
With respect to currency exposure, our EM holdings are currently all denominated in U.S. dollars. However, local currency debt offers another lever to improve the portfolio’s return and diversification attributes, and we may opportunistically seek to take advantage of it. Recognizing the fact that exposure to local currency assets introduces significantly higher volatility, Signature has built a team with dedicated EM FX capabilities, which are crucial to managing risks related to local currency investing.
The role of EM debt within the Signature fixed income suite
We manage around US$550 million in EM assets across our fixed income mandates, certain balanced funds (such as Signature Global Income and Growth Fund), as well as a dedicated strategy outside our mutual fund suite of products. To illustrate the role EM fixed income plays as a value-added lever, the following tables provide a detailed breakdown of the drivers of performance in Signature Tactical Bond Pool and a snapshot of how our EM investments fit into the Signature fixed income suite.
As discussed above, we believe EM debt has a place in investors’ fixed income portfolios, with allocations sized according to the investment objectives and target tracking error of each fund. For instance, our Canadian-centric mandates have significant exposure to spread products –through government and investment grade corporate credit—and a relatively narrow target tracking error range. This warrants a smaller allocation to EM sovereign spreads as a way to enhance portfolio income and diversification. Therefore, Signature Canadian Bond Fund has a target exposure to EM debt of roughly 1% market value.
At the other end of the spectrum, Signature Global Bond Fund has a much smaller exposure to spread products and allows for a larger tracking error. For these reasons, the fund has a target exposure to EM of around 10% market value. As for Signature Tactical Bond Pool, this fund draws on a variety of levers to optimize risk-adjusted returns, including government credit, investment grade credit and high yield bonds. While the target tracking error range is wider than that of Canadian mandates, the maximum aggregate exposure to high yield and EM credit is capped at 10%. Hence, the target EM debt exposure is approximately 3% market value.
As of March 31, 2017, Signature Tactical Bond Pool has outperformed the FTSE TMX Canada Universe Bond Index by 0.04% (this relative performance and breakdown below is expressed gross of all fees and taxes). While duration and yield curve positioning, exposure to preferred shares and inflation linked bonds all contributed positively to alpha performance, the 3.4% allocation to EM sovereign bonds contributed 0.06%, a sizable portion of excess returns relative to the aforementioned benchmark.
 As a reference point, the J.P. Morgan EMBI Global Index, which tracks U.S. dollar denominated sovereign and quasi-sovereign bonds, returned 10.26% for the full year 2016, while the 6-month total return from March 31 through September 30, 2016 came in at 9.34%. Year-to-date as of March 31, 2017 the index has returned 3.90%.
 The J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) is a US dollar emerging markets debt benchmark that tracks total returns for actively traded external debt instruments in Emerging Markets. Eligibility rules for this index include instrument-level liquidity requirements and ratings to be Baa1/BBB+ or below by Moody’s/Standard & Poor’s, respectively.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the funds referenced herein, their future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise indicated, the indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. First Asset Investment Management Inc., manager of First Asset Long Duration Fixed Income ETF, is an affiliate of CI Investments Inc.