In this Q&A, Capital Group fixed income investment director James Blair discusses the characteristics of emerging market debt, how investors could approach investing in the asset class and the US Federal Reserve (Fed)’s policy response to the recent market volatility.  

 

Emerging markets are heterogeneous – the broad sector obscures a lot of subtleties and the terms used can be confusing. What are the main investable emerging market debt (EMD) sectors? 

Most investors recognise that EMD is a very broad asset class, but they may not be aware of the extent of that diversity. There are broadly two main categories - the hard currency and local currency markets. EM hard currency bonds can be issued by governments (sovereigns) or companies (corporates) in a major currency – generally in US dollars but also in euros. They are essentially a credit asset, typically offering a yield pick-up over US Treasuries (in the case of US dollar bonds) as compensation for taking on additional risk. They can be investment grade or high yield. Investors seek this extra yield to help cover losses that may arise from default and in some cases a liquidity premium. This spread is chiefly influenced by changes in the credit profile of the issuing entity and by global fluctuations in investor appetite for risk. 

Local currency denominated bonds are mainly issued by sovereigns but can also be issued by corporations in EM countries, and they are issued in their own currency. They can be split into nominal bonds, which can have either a fixed or floating interest rate, or inflation-linked bonds where returns are tied to inflation. These are the more traditional bond markets, in that they are more interest rates-based markets rather than credit-based. Changes in domestic interest rates and shifts in the shape of the yield curve are the main drivers of returns, while improving creditworthiness is a less prominent contributor. There are exchange rate considerations with local currency markets and so currency hedging decisions can be important. 

This year has highlighted the breadth and differences between the different markets and countries. In hard currency bonds, there’s been a marked return difference between commodity related issuers and those with more diversified economies. The return dispersion between investment grade bonds, which have held up fairly well, and the lower rated high yield issuers, which have underperformed and are still trading at elevated credit spreads, is just as stark. 

 

What variables do you and your team look at when assessing EMD investments?

Given the disparate nature of the EMD universe, there are a number of factors that we take into account when assessing investments in the asset class. They can generally be categorised as falling under three broad categories: fundamental factors, valuations and technical factors. 

Firstly, fundamental analysis looks at the key factors driving the issuer and their economy and how these variables might change. For a sovereign issuer, you might be looking at the external funding requirements of the economy (the current account deficit + short-term debt + amortisation of medium-term debt falling due in the next 12 months) and exchange rate reserves. Then there are domestic considerations, such as the budget deficit, economic growth, inflation, etc. 

Secondly, valuation analysis would consider what is priced into the sector and the issuer and how this might change over time. We would look at factors such as the price of EM debt relative to other asset classes, the EMD asset class relative to historical prices of the sector itself and within EM debt, and how bonds of similar fundamentals compare on price. We also look at pricing along the issuer’s yield curve for potential pricing anomalies. 

Finally, there are the technical factors and that covers a broad range of other factors. Some of them might be the market forces for the purchase or sale of bonds, so for example if there is a large amount of new issuance, that could weigh on market pricing or changes in weights of countries in widely-followed indices, which can lead to large amounts of buying or selling. Market risk appetite is another factor - this can vary depending on the behaviour of the investors. Also, market microstructure considerations can be important, such as one that we’ve all been dealing with recently which is the impact of working from home and sell-side trading capacity, or the impact of exchange-traded funds (ETFs).  

Dislocations between valuations, fundamentals and technicals can create compelling investment opportunities. We can look at some country examples. Argentina is heading into sovereign default and so clearly has weak fundamentals, but it might be the case that the USD denominated bond recovery values are higher than what is currently priced into the bonds, so some investors might buy these bonds on valuation grounds – even though they expect a default. It’s a similar situation in Ukraine – the bonds have sold off significantly and our analyst believes that some of the bonds offer decent value assuming the government manages to secure an IMF lending programme. In the current volatile environment, we might look at some local markets that have a large domestic buyer base such as China, as these markets will be less impacted by global volatility. South Africa, meanwhile, faces a double whammy of weak fundamentals and poor technical factors, as its recent downgrade meant that it was taken off the benchmark World Government Bond Index, which has triggered a huge amount of forced selling. 

There’s not always a clear distinction between the three factors. Indeed, the largest single driver of returns this year has been the actions of the US Federal Reserve. It has impacted fundamental factors, it has underpinned valuations and it is providing strong technical support for credit markets. 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or highyield securities; emerging markets are volatile and may suffer from liquidity problems.