Published May 2017
Why should I invest in emerging markets debt (EMD) now?
EMD has matured significantly over the past 15 years and we believe EMD should increasingly be a key long-term component in every investor’s portfolio. In this piece, we would like to highlight a few key reasons why we believe EMD currently offers an attractive investment opportunity for long-term investors.
Emerging Market (EM) sovereigns are now better equipped to combat exogenous shocks.
- EM economies have learned from lessons of the past and recent macroeconomic adjustments have left EM countries well-positioned to absorb external shocks.
- Commodity price stabilization and recovery should provide a near-term backstop amid global uncertainties.
- Favorable demographic trends and a rise in purchasing power provide select EM countries with a positive backdrop for a constructive longer-term outlook.
Attractive valuations and compelling risk/return characteristics offer a cushion against rising US interest rates.
- With developed country yields at relatively low levels, EMD continues to offer attractive valuations and yield levels even after a nice rally in calendar year 2016.
- Adjusted for ratings, yields of USD-denominated bonds in EM are attractive relative to its developed markets (DM) counterparts.
- For investors with a long-term time horizon, we continue to view broad market corrections as offering attractive entry levels to gain exposure.
Capital flows have strengthened over the past year.
- Portfolio flows slowed after the Taper Tantrum of 2013 and EMD became an unloved asset class for the few years that followed; however, improved investor sentiment due to the relative attractiveness of yield and fundamentals of the asset class helped EMD post record inflows more recently.
- Stronger capital flows also continue to change the composition of the EMD asset class, presenting a wide array of attractive opportunities for investors.
EMD has undergone significant structural improvement over the past several years.
- Maturation of the three distinct sectors of EMD (USD sovereign, local currency sovereign and USD corporate credit) affords skilled managers the flexibility to allocate to and rotate among the most attractive sectors in different market environments.
- The EMD investable universe (as defined by the market values of J.P. Morgan EMD indices) is a large, high-quality, and liquid market with a diverse investment opportunity set, offering numerous pockets of value opportunities for investors to exploit.
- Capital from the continued growth of EM countries’ pension funds has created a stable and steady demand for local currency sovereign debt, providing foreign investors a comfort level that did not exist even 10 years ago.
The EMD asset class has proven itself to be a resilient asset class.
EMD has recently proven itself to be a resilient asset class and has held up well during recent bouts of volatility. For example:
- Brexit: Immediately after Brexit, risk assets sold off and EMD was no different; however, as time passed, EMD recovered and was one of the best performing assets classes in calendar year 2016.
- Trump Victory: In addition to Brexit, EMD also recovered nicely after Trump’s victory despite Trump’s tough talk on immigration, trade and protectionist policies, and, as a whole, has continued to perform relatively well into 2017.
What areas of EMD specifically are you seeing as attractive value opportunities?
For long-term investors with tolerance to volatility, we view local currency EMD as attractive. Central bank cycles in EM countries appear desynchronized against their DM counterparts, as monetary policy tightening in prior years have provided the scope for easing in the face of abating inflation pressure.
More broadly, market fears over Fed tightening have mostly been priced in. For credit investors, USD-denominated bonds issued by governments and corporates are cheap versus DM opportunities. We look for “safe carry” in bonds issued by quasi-sovereign companies with systemic importance.
How does an EMD allocation contribute to a broader global portfolio?
High-quality EMD offers a distinct benefit of diversification away from DM government bonds. From a valuation standpoint, there is still a significant yield appeal versus DM opportunities. Fundamentally, DM economies face significant long-term structural headwinds, for example demographics. While EM countries have their own challenges, the cyclical downdraft experienced since the Taper Tantrum of 2013 has exerted urgency and incentive for governments to pursue domestic economic reforms. From a technical standpoint, we anticipate the progressive index inclusion of select EM local markets as likely to have a salutary effect on international investor participation.
Is active investing in EMD advantageous relative to a passive approach?
As an asset class, EM is unique in that its constituents comprising over 70 countries are highly diverse. The feature of heterogeneity in EMD, we believe, reinforces the case for active management. It presents an evolving set of opportunities to differentiate, customize and rotate across segments at specific points of the market cycle. Accordingly, we are not advocates of an index-based, wholesale approach to EMD investing. Having exposure to a sovereign bond simply because it is in the index, while not intentionally, represents a tacit sponsorship for bad credits. In the context of a highly volatile asset class such as EMD, the return of capital must precede the return on capital.
What is Western Asset’s approach to investing in EMD?
Our EMD strategies are based on Western Asset’s hallmark investment philosophy: a long-term fundamental value approach using multiple diversified strategies. This approach is based on secular themes that drive investment decisions with respect to country, sector and issuer selection.
Differentiating the winners within the EMD investment universe requires a rigorous research process that identifies countries and corporations that possess the capacity to manage during times of global economic weakness. The EMD Team at Western Asset favors those organizations that exhibit prudent policy making and excellent governance, and continues to emphasize differentiation and a high-quality approach with exposure to countries and corporations that consistently demonstrate fiscal discipline (and for sovereigns, strong FX reserve accumulation).
Western Asset seeks to capitalize on its globally integrated platform leveraging boots-on-the-ground around the globe to formulate specific views on countries and companies within the context of global trends in specific industries. Our EMD Team leverages the global themes emanating from our offices in Europe, the US, Latin America, and Asia, by integrating and synthesizing ideas into an overall EM portfolio that seeks to balance a multitude of investment opportunities against global risk considerations.
Why should I hire Western Asset for my EMD allocation?
Western Asset successfully combines the benefits of a specialist EMD boutique manager with the benefits of a world-class global fixed-income firm. This has become increasingly important for the management of EMD mandates as they are ever more impacted and influenced by exogenous forces, both macroeconomic events and global fund flows.
The Firm’s sizeable assets under management give Western Asset market clout and access to broker-dealers, policy makers and management at the corporations in which the Firm invests, but the size does not prevent the Firm from taking advantage of market opportunities when they arise.
- Focused/Dedicated: Western Asset has a specialized EMD Team consisting of 36 dedicated EMD professionals with deep and broad experience. Key members of the Team have weathered past crises together (e.g., Mexican peso crisis, Asian debt crisis, Russian debt crisis, global financial crisis), which has resulted in the Team’s ability to adapt to a rapidly evolving investment environment.
- Experienced: Western Asset has been managing EMD allocations in broad mandates since May 1993 and dedicated EMD strategies since July 1996. The Firm has capabilities managing individual sectors across the EMD spectrum, including USD sovereign/quasi-sovereign, USD corporate credit, and local currency sovereign.
- Global: Western Asset has 856 employees in nine offices on five continents, including a global investment team of 125 investment professionals. The Firm manages $37.4 billion in EMD assets as of 31 Dec 2016 with the ability to trade and settle in all time zones. Global resources enable the Team to better quantify external risks to owning EMD, allowing the Team to better manage each strategy’s risk profile.
- Strategically Positioned: The line between developed and emerging markets is becoming increasingly blurred; Western Asset has a long track record of successfully managing global portfolios and is strategically positioned to leverage complementary capabilities in both developed and emerging markets to deliver comprehensive fixed-income solutions as EMs continue to evolve and mature.
- Corporate Credit Expertise: Expertise in credit analysis of corporations across the globe (a core strength of the Firm) is leveraged for EMD country and currency analysis. Accessibility to senior management of companies in emerging market countries enables the EMD Team to identify trends in local economies and supplements country analysis. The Firm is a member of the JPM CEMBI Index Advisory Committee and the sub-advisor to the first-ever actively managed EMD Corporate Credit ETF (NYSE ticker: EMCB).
- Disciplined: Western Asset, as well as the EMD Team specifically, employs an integrated risk management process, which includes an independent evaluation of strategies and risks in all EMD portfolios. The Team formally meets with the Firm’s Chief Risk Officer, Head of International Risk Management, and portfolio risk analysts in charge of EMD portfolios on a monthly basis to discuss the major risk themes surrounding EMD portfolios.
Western Asset continues to shape the development of the EMD asset class. Western Asset’s thorough understanding of the EMD universe gives it the unique ability to provide customized solutions that seek to meet client objectives.