Portfolio Manager Q&A

Transcription

1 Insight Portfolio Manager Q&A November 2014 Anna Troup, a Portfolio Manager within the Emerging Market Sovereign Debt team, answers some questions about the current trends within the asset class How is the emerging markets sovereign fixed income universe likely to evolve? We expect many of the current trends driving this asset class to continue. Among the most pertinent is the growth in the overall market capitalisation of the emerging market debt (EM) asset class, driven by the growth of local currency sovereign, together with hard and local currency corporate, debt. We would also expect mainstream EM countries (e.g. Brazil, Mexico and Turkey) to continue shifting away from hard currency sovereign issuance towards local currencies, whereas corporates from these countries should remain active in the external currency new issue market. This would result in a local currency index containing the more developed emerging economies, such as Brazil, Mexico and Poland, while the hard currency index would include some countries defined as more frontier in nature, such as Gabon, Namibia and Guatemala. This is reflected in the average credit rating of each index, with the JP Morgan EMBI Global Diversified rated BB+/Baa3 (S&P/Moody s), and the JP Morgan GBI- EM Broad Diversified rated BBB+/Baa1 (S&P/Moody s). We also anticipate that the proportion of EM local currency corporate debt as a percentage of overall corporate issuance would rise, as the asset class becomes more established and attracts more interest from foreign-based investors. The current investable market size for each EM sub-asset class is shown in Fig. 1. Anna Troup Partner, Portfolio Manager Fig. 1 Investable market size of EM sub-asset classes EMD hard currency EMD local currency EMD corporates hard currency EMD corporates local currency Approx. inves ble market size (US$) $1.4tr $2.6tr $1.4tr $4.0tr Data source: BlueBay Asset Management, March 2014 Portfolio Manager Q&A Page 1

2 From an investor perspective, we believe there will be continued product innovation to make the asset class easier to access. To begin with, the components of a blended EM strategy will be more reflective of the changing composition of the overall asset class. Ten years ago, the term EM blended was defined as a combination of EM hard currency and local currency sovereign debt. Over the last five years, the growth in the EM corporate debt asset class has been substantial, and it is has become commonplace for dedicated EM investors to have a standalone corporate allocation, in addition to their EM sovereign debt portfolios. More recently, the rapid growth of the EM local currency debt market and establishment of an investable index has placed the asset class more in the spotlight for foreign-based investors. In the near future, a blended EM mandate would likely include both varieties of sovereign and corporate debt. Furthermore, investors are looking for long-only EM solutions whereby they ask managers to make asset allocation decisions for each EM sub-asset class. This is because different global macroeconomic environments impact different areas of EM in varying ways, so it is beneficial for managers to have the flexibility to shift their allocations when prudent to do so. In line with this, certain investors want to manage their emerging market exposure through a more concentrated portfolio with a less constrained management approach, enabling managers to fully exploit the differentiation between countries and sub-asset classes. At BlueBay, we have flagships funds in each of these single-sector EM strategies, and manage a variety of blended, pooled and segregated mandates. In 2005, we launched our Emerging Market Select strategy, which is managed to a 50% EM hard currency sovereign index (JP Morgan EMBI Global Diversified) and 50% EM local currency sovereign index (JP Morgan GBI-EM Broad Diversified). Apart from the quasi-sovereign corporates that constitute the JP Morgan EMBI Global Diversified Index, additional corporate exposure as off-benchmark positions is limited to 20%, and we will only purchase corporates whose liquidity profiles match other benchmark positions (e.g. issuance size of US$500 million or greater). At BlueBay, we have a history of monitoring trends within EM and launching products to capitalise on these. This is evidenced most recently by our launch of the BlueBay Emerging Market Local Currency Corporate Bond Fund, where we worked closely with Bank of America Merrill Lynch towards the inception of a local currency corporate benchmark, which has enabled us to gain an early track record in this growing asset class. We continue to monitor these investment trends and aim to remain at the forefront of the evolution of the asset class as a whole. Which are the market/economic scenarios in which the asset class would struggle or run into some difficult times? The market environment in which EM fixed income can struggle is one in which markets do not discriminate across issuers and there is instead a broad-based selloff in the asset class due to an EM-specific or global macroeconomic risk event. This was how EM has historically traded. However, in recent periods there has been far more differentiation within the asset class, as EM countries have traded on their fundamentals rather than being grouped together in a homogenous bloc of developing countries. As the universe contains economies of all sizes, types, strengths and weaknesses, there are always countries where one might want to be overweight or underweight and those that one would rather not be exposed to. Certain market environments will have a differentiated impact on EM countries. For example, the recent slowdown in commodity prices is a headwind for countries such as Nigeria and Venezuela, which have a high dependency on energy exports. Conversely, for energy importers such as India and Turkey, the fall in commodity prices is a positive trend. Another scenario in which the asset class could run into difficulty would be when investors become complacent and look through idiosyncratic risk within the asset class. A topical example of this is Argentina, which has continued to trade well Over the last five years, the growth in the EM corporate debt asset class has been substantial The rapid growth of the EM local currency debt market has placed the asset class more in the spotlight for foreign-based investors Page 2 Portfolio Manger Q&A

3 despite being in default. Argentine bonds in the JP Morgan EMBI Global Diversified index returned % over 2014 YTD 1 and a further +2.44% since the default at the end of July, and we believe that investors are significantly underestimating the extent of economic deterioration in the country and are currently too complacent over the risks presented by a delay to restructuring. This is another example of a market where countries have ceased to trade on their underlying fundamentals, which could cause difficulties for the asset class. Data source: 1 Bloomberg, JP Morgan, year to 11 November Index: J.P. Morgan EMBI Global Diversified Argentina What are the differences for euro or US dollar-based end investors when investing in emerging market local currency sovereign debt? Emerging market local currency sovereign debt is regarded as a risk asset by both European and US investors, thus there is a set of distinctive risk premia that need to be taken into account by both sets of investors. Firstly, the asset class is broadly traded in portfolios where the base currency is US dollars, and the index is US dollar unhedged. The reason for this is the greater liquidity in EM currency pairs traded versus the US dollar than for any other alternate developed market (DM) currency. Therefore, dollar-based investors have a natural hedge, given that a stronger US dollar tends to be negative for emerging market local currency assets. Conversely, a euro-based investor has to consider the dynamics of the US dollar versus both the EMFX and euro/us dollar/usd. There is a set of distinctive risk premia that need to be taken into account by investors Fig. 2 EM rates beta to US Treasuries 4.0 EM Rates Beta to UST (1yr period) Brazil Hungary Poland Turkey Romania Israel Mexico Peru Chile Indonesia Korea China Colombia Thailand India Malaysia South Africa Philippines Russia Data source: BlueBay Asset Management, 11 November 2014 Secondly, while the duration of the asset class at an index level is a blend of the duration characteristics of the 18 constituents of the index, the asset class still has a high beta to US Treasuries. As shown in Fig.2, the degree of sensitivity does vary by country and by region, with markets such as Mexico having a beta of close to 1. European emerging market economies, such as Poland, Hungary or Romania, have seen their weightings within the index increase in recent years. For these countries, the strongest external influence from a rates perspective has been the European Central Bank (ECB). Thus, another variation in risk premia is the current dynamic of divergent central bank policy in Europe and the US. Assuming that the cost of capital stays lower for longer in Europe, and inflation remains below that of the US, then the real yield advantage for a European investor should be higher, and the carry seem more attractive. The ECB is currently more focused on combatting Portfolio Manager Q&A Page 3

4 deflation, as evidenced by the recent additional reduction in ECB rates and its commitment to a programme of asset-backed security (ABS) purchases. Thus, the real yield pick-up for European investors is greater. How are the risk premia within emerging market local currency sovereign debt best defined? We would separate risk premia into two broad categories; structural risk premia as a long-term risk, embedded in the particular market, while distinctive risk premia can be seen as being more idiosyncratic in nature. It could be argued that there is no credit risk involved when investing in the asset class, as you are buying the closest thing to a risk-free asset; a sovereign bond issued in the local currency. Only in extreme scenarios, where there is rapid inflation or currency depreciation due to the unorthodox nature of policymakers, would a foreign investor express concern that their capital was at risk. However, there are certain occasions when distinctive credit risk premia can arise in a market when a local currency sovereign bond has a high correlation to its sovereign hard currency credit equivalent. At certain points this year, Russia has been a good example of a country that has traded in this way, when movements of the Russian local currency sovereign curve could be explained by investors perception of geopolitical risk and the implications of sanctions on instrument liquidity. This was in contrast to the short end of the curve being driven by monetary policy expectations, or the longer end being influenced by inflation and growth dynamics. A structural risk premium that is prevalent in Eastern Europe is the fact that the front end of bond curves are broadly anchored, due to lower inflation pressures and the accommodative monetary policy stance of the ECB. We would define this as an example of a structural risk premium since the theme can persist for a sustained period of time. The shape of individual bond curves, and their degree of steepness, can vary due to distinctive risk premia. One example would be the reform of the domestic pension industry that occurred in Poland in December The structural risk premia that exist within FX relates to the nature of the currency regime in question, specifically if it is a free-floating, pegged or fixed exchange rate. The South African rand operates as a free-floating currency and therefore there is little, or no, structural premium embedded in the FX instrument, as the currency forward rate is priced at an accurate reflection of the underlying spot rate. However, China does not have a free-floating FX market, which can lead to a divergence in performance between the spot and forward markets. The nondeliverable forwards are influenced by a range of additional factors relative to forwards for currencies with free-floating currency regimes, such as the portfolio flows of offshore managers. A distinctive risk premium worth noting is the differing levels of foreign exchange reserves across the emerging market universe. A central bank like Banco do Brasil, which has adequate levels of foreign exchange reserves and has shown a willingness to intervene in times of market stress, can smooth intra-day volatility relative to the Central Bank of Turkey, where the ability to intervene is more constrained. A distinctive risk premium is the differing levels of foreign exchange reserves across the emerging market universe It is not possible to invest in certain countries passively, notably China What are the main obstacles to implementing a semi or smart passive investment approach in emerging market local currency sovereign debt? Firstly, it is not possible to invest in certain countries passively, notably China. Other countries, such as Indonesia, can be accessed by foreign investors, but are subject to significant tax penalties. These tax regulations are subject to change at any point, for example Brazil s 6% financial transactions tax, known as the IOF, which was cut in June Prior to this, an active manager would have been able to use derivatives to replicate exposure to the underlying cash bonds, while passive managers would have had to stick to markets where only plain vanilla instruments could be used. Page 4 Portfolio Manager A&A

5 Secondly, in a passive investment approach to emerging market local currency debt, you would be unable to isolate rates and FX returns separately. This is vital, as the long-term correlation between the rates and FX components within emerging market local currency has been decreasing. Investors need to look at each of these separately to trade effectively, as a positive local rates environment may not necessarily translate into a favourable FX environment, i.e. a central bank that consistently cuts rates. There are many drivers of emerging market local currency assets that cannot be captured outside of active management, such as changes in index weights and changing auction profiles. Earlier this year, Colombia s weighting in the JP Morgan local currency indices increased, partly due to increased liquidity in Colombian local markets, and increased transparency with international investors. This resulted in a rally in Colombian local debt, and as an active manager, we were able to take advantage of the rally resulting from this increased weighting before passive managers were able to invest. A recent example of how issuance calendars may vary over time is in Russia, where the Ministry of Finance stopped issuance in the short term in order to provide technical support for the bond market. This example highlights how auction profiles can change and have a direct impact on performance. The long-term correlation between the rates and FX components within emerging market local currency has been decreasing What are the benefits of actively managing FX exposure within an emerging market local currency portfolio? Fig. 3 illustrates the aggregate index and individual country returns split out by rates and FX. Fig. 3 Return of the JP Morgan GBI-EM Broad Diversified Index (%) GBI Asia Europe Lat Am Div Mideast/Africa Brazil Chile China Colombia Hungary India Indonesia Malaysia Mexico Nigeria Peru Philippines Poland Romania Russia South Africa Thailand Turkey There are many drivers of emerging market local currency assets that cannot be captured outside of active management Data source: Bloomberg, JP Morgan, year to 11 November Index: JP Morgan GBI-EM Broad Diversified Index Portfolio Manager Q&A Page 5

6 There is always a sufficient degree of differentiation within the asset class to allow investors to have differing long and short views in each market. For example, Hungarian rates have delivered strong returns in 2014 year to date, but an investor that did not hedge out the exposure to the forint would have received a negative overall return, as the FX more than offset the rate performance. The underperformance in the forint can be attributed to the central bank persisting with its policy of cutting rates, concerns over fiscal sustainability and a high reliance on external funding. This left the currency vulnerable to most of its EM peers and we have subsequently maintained an underweight position in the forint within our EM local currency strategy so far this year. EMFX cannot be viewed in isolation, as EM currencies are predominantly traded against the two major DM currencies, either the US dollar or the euro. There are certain global macro developments which can broadly provide a favourable, or less favourable, backdrop for all EM currencies. Currently, a dominant theme that is influencing the direction of EMFX versus DM currencies is divergence in central bank policy and rate expectations between the Federal Reserve and the ECB. The expectation of higher US rates will lead to risk premia increasing and contribute to dollar strength. In contrast, the continued ECB easing following a much slower growth recovery in the eurozone will lead to depreciation of the euro versus the US dollar. Therefore, market forecasts are for EM currencies to outperform versus the euro, but underperform against the dollar. In addition, there are still tail risk scenarios that would also lead to EMFX underperforming versus the US dollar and the euro. For example, the onset of geopolitical concerns leading to a shock to risk sentiment and a subsequent repricing of global risk assets. This shock could come from an escalation in Middle East tensions or from a major shock to growth expectations in the US or China. In this scenario, while all EM currencies would be expected to underperform, we believe the extent of the negative returns would be dependent on the composition of specific economies and the nature of trade linkages with the rest of the world. For example, in the event of weaker-than-expected Chinese growth data, demand for copper would tend to fall, leading to an underperformance in the Chilean peso as copper exports are a key source of external revenue for the country. Fig.4 shows the returns for the GBI-EM Broad Diversified split into local currency, US dollar and euro. The returns in every period would differ markedly based on an investor s base currency. If we look at the year-to-date return period, a European investor would have a significant advantage over a US dollar-based investor, based on the relative currency performance so far this year. There is always a sufficient degree of differentiation within the asset class to allow investors to have long and short views in each market Market forecasts are for EM currencies to outperform versus the euro, but underperform against the dollar Page 6 Portfolio Manager Q&A

7 Fig. 4 JP Morgan GBI-EM Broad Diversified returns by currency Historical returns and return components, local currency, USD & Euro (un)hedged Local currency return Unhedged in US$ Hedged in US$ Unhedged in Euro Hedged in Euro 1m 3m YTD 12m 1m 3m YTD 12m 1m 3m YTD 12m 1m 3m YTD 12m 1m 3m YTD 12m GBI-EM Broad By region Asia Broad Europe Broad La n Broad MidEast/Africa Broad GBI-EM Broad Diversified By region Asia Broad Diversified Europe Broad Diversified La n Broad Diversified MidEast/Africa Broad Div By country Brazil Broad Chile Broad China Colombia Broad Hungary India Indonesia Malaysia Mexico Nigeria Peru Philippines Poland Romania Russia South Africa Thailand Turkey Data source: JP Morgan, as at 31 October 2014 This document is issued in the United Kingdom (UK) by BlueBay Asset Management LLP (BlueBay), which is authorised and regulated by the UK Financial Conduct Authority (FCA), registered with the US Securities and Exchange Commission, the Commodities Futures Trading Commission and is a member of the National Futures Association. 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