Alejandro Arevalo
Fund Manager, Emerging Markets Debt
Alejandro Arevalo, Fund Manager, Emerging Market Debt, discusses the benefits of taking a short duration approach to investing in emerging market debt. He also explains why he thinks an active, flexible approach is key to delivering attractive risk-adjusted returns.
Investors cannot ignore the wealth of investment opportunities offered by the emerging market debt (EMD) asset class. In a world of ultra-low or negative rates, investors have to look outside of developed markets in the ‘hunt for yield’. There is still around $16tn worth of negative yielding debt globally, and just 9% of global fixed income markets offer investors yields of over 3%1 – with unprecedented levels of coordinated monetary stimulus on a global scale, this is unlikely to change dramatically any time soon. The EMD asset class not only offers huge diversification, encompassing around 100 countries at varying stages of their economic cycles, but it also provides access to high economic growth, with around 70% of global growth coming from emerging markets. With a growing investor base, EMD has been one of the fastest-growing fixed income sectors over the past decade, expanding into a widely diversified $23tn market, which is the same size as around 50% of all developed market government and corporate debt combined.
Where is the yield
Source: JP Morgan Global Aggregate Bond Index as of August 2020
While the opportunities offered by EMD are evident, risk appetite towards emerging markets does still tend to swing dramatically, from periods of indiscriminate buying when sentiment is strong, irrespective of credit fundamentals, to selling ‘at any price’ when conditions are looking tough. But a more challenging macro backdrop doesn’t mean that investors should shy away from the asset class. Instead, an EM short duration bond approach can provide more cautious investors with exposure to the yield premium offered by EMD, while also limiting the impact of macro volatility.
The benefits of short duration
Carefully selected short duration emerging market bonds offer the benefit of attractive yields compared to developed market counterparts, but with lower volatility than broad duration bonds. This is because short duration bonds benefit from the ‘pull-to-par’ effect: as a bond gets closer to its maturity date, its price will begin to reflect only its credit default risk. If the bond doesn’t default, it will pay back its face value, irrespective or what happens to the US Treasury rate and other macro factors. This makes short duration bond strategies much less volatile than those with a broad duration. In fact, the volatility of a 10-year bond is as much as 9x higher than that of a bond with a maturity of 3 years.2
By investing in shorter duration bonds and holding them to maturity, investors can therefore ‘lock in’ the yield-to-maturity while significantly reducing the volatility risk. Short duration bond funds can be used as a ‘cash proxy’. As a significant portion of a short duration fund matures, the high yield materialises into positive returns, independent of market conditions.
An active, flexible approach is key
A short duration strategy can allow investors to benefit from rallies when markets are more buoyant, while limiting downside risk in tougher times. However, in order to achieve attractive risk-adjusted returns, we believe an agile, fundamentals-focused approach is vital, allowing us to respond as the facts change, and take advantage of opportunities as they arise. Accurate credit analysis is required to identify the names with the strongest fundamentals, which are also trading at attractive valuations. It is important to monitor global macro developments too, in our view, and to reposition investments accordingly if the backdrop changes.
Turning challenges into opportunities
We take a defensive approach to investing, conducting careful analysis on countries and individual credits with a focus on valuations and limiting drawdowns. Over the past three years, there are many examples that demonstrate our ability to participate in market rallies, while effectively managing drawdowns.
In the first quarter, as the Covid-19 pandemic resulted in lockdowns across the globe, and markets faced their largest shock since the Global Financial Crisis, we applied three key strategies to our investment decisions. First, we tried to avoid major pitfalls by identifying the credits that we believed were most vulnerable to the pandemic and the resulting drop in economic growth. We quickly identified and reduced our exposure to names that did not appear to have a sufficient cash cushion to weather the shock. Second, we bought bonds that got caught in March’s indiscriminate market sell-off, where strong fundamentals were being undervalued. Finally, we maintained our disciplined approach and did not panic alongside markets, holding onto many names with solid fundamentals that we believed should not only survive the crisis, but which could come out of it stronger.
While spreads have tightened since March’s selloffs, overall, we still think emerging market debt valuations remain at attractive levels, especially relative to their developed markets counterparts. However, as always, we believe it is important to be selective when adding risk, and that security and country differentiation is key, particularly in the current market environment.
1. Source: JP Morgan Global Aggregate Bond Index as of August 2020
2. Based on US Treasury data
