Investment - Credit where credit’s due 2.0 – an intro to Emerging Market Debt - Episode 155

Hello and welcome to Hyman's Robertson on Investment, a podcast series for everyone and anyone interested in all things institutional investment. My name is Kiara Beton and I'm an investment research analyst at Hyman's Robertson. In this series of short podcasts, we'll cut through the noise to discuss the investment topics that we believe are most pertinent for institutional investors. Please note this podcast is for information purposes only and does not constitute any type of investment or actuarial advice. For more information and all of the usual disclaimers, please see our website at hyman's.co.uk/ensites. Before we get stuck in, we'd like to remind listeners that there are risks associated with emerging market debt as an asset class. Some areas of the market are riskier than others and country-specific and geopolitical factors can affect returns. Equidity is another risk and something that should be weighed up in the context of a long-term portfolio. We should also note that opinions expressed in this podcast are the interviewees only. We don't necessarily share them. I'm delighted to be joined today by Serena Galestian to discuss emerging market debt and why investors have been interested in allocating to the asset class recently. Welcome and maybe we could kick off with a quick introduction first. My name is Serena Galestian, head of the EM debt investment specialist team at Amundi. Thanks for joining me today, Serena. Before we discuss the interest in emerging market debt, we should perhaps start by delving into the asset class itself. Serena, could you please give the listeners an eye a brief overview of emerging market debt or EMD for short? Sure. So let's provide you with a brief overview. Energy market debt covers bonds issued from countries considered as developing or emerging. The asset class is comprised of three segments, hard currency debt, which are bonds issued in dollars or euros, local currency debt, which are primarily sovereign issued, and hard currency corporate bonds as well. Local currency debt also has an FX component, which is another source of return and volatility to consider as well. I would like to highlight a few points. Firstly, the universe has evolved significantly in the last two decades, given the remarkable broadening and growth in the number of issuers and countries. It is now a diverse universe that covers over 70 countries in the hard currency space and over 20 countries that issue in local currency. As a result, since 2010, the EMD universe has nearly tripled in size with the asset class expanding to 26 trillion from over 10 trillion previously. Now, because of this remarkable growth, the share of EM in global bond markets has rapidly increased to nearly 30% from 8% in 2003. However, EM remains underrepresented in global bond indices at around 15% of global aggregate indices on average. Thanks. That's a helpful overview. It's striking how much the universe has expanded and diversified over time. To perhaps build on this overview, what are the key characteristics of the asset class? There are a few areas I'd like to highlight which make the asset class worth taking a closer look. Firstly, is the yield advantage EMD offers versus other fixed-income asset classes. Emerge your market debt is often compared to global high yield, but continues to offer a higher level of yield for better average credit quality. The average credit quality of EM hard currency debt is currently double B+. But the rating is really on the cost of being investment-grade rated. As EM local currency and corporate debt have an average rating that is currently investment grade, US high yield and contrast has an average rating of double B+. Secondly, it's the diversification element it provides to a global portfolio of bonds and equities. Given the diversity and dispersion across emerging markets with varying business cycles, long-term historical correlations are quite low with global government bonds and global equities as well. And in some cases, even negative, like with US treasuries. Thirdly, is the notable improvement in fundamentals across emerging countries over time? Macarachonomic stabilization programs, often in partnership with the INF, have led to structural reforms, and moves toward floating exchange rates and stronger growth prospects as well. As a result of these efforts, in the last 25 years, EMS' share of global GDP has expanded from around 25% to nearly 50% today. EM's share of global financial wealth has also increased, as economic models have shifted toward being more domestic demand driven. As a result, fundamentals have improved as inflation has declined and currencies exhibit greater stability than we've seen in the past. Lastly, I'd like to point out that the size of the universe, number of countries and heterogeneity across the universe, means there are plenty of opportunities to add value, as there are still inefficiencies that exist in the market. This is unlike developed market fixed income, which offers relatively fewer mispricing opportunities. It's clear that the structural and fundamental evolution of the market offers a vast opportunity set. I observed last year EMD had robust strong performance. What drove that level of return? Well, the macroeconomic backdrop over the last few years has been very supportive for credit. As financial conditions have eased, global growth is resilient while inflation has slowed from the COVID period, thereby enabling major central banks to ease monetary policy. Consequently, credit spreads are now at historical tights in many markets. As a result, for the first time since 2021, inflows have actually returned to the asset class, with estimates around 30 million of inflows over the last 12 months. We expect this to continue this year and beyond, as investors look for higher yielding alternatives. From evaluation perspective, starting with hard currency debt, there are still segments of the market that are attractively valued, like high yield, for example, or select frontier markets. Especially as many countries have sought financing from the IMF, and as part of that, have embarked on structural reform programs, local currency debt has also had stellar returns over the last couple of years, benefiting from a weaker dollar and evidence of US dollar diversification efforts on the part of many large institutional investors. Less favorable interest rate differential due to Fed cuts could likely see further pressure on the dollar, and the IM local currency has poised to benefit in our view, particularly in those countries that have hiked rates and offer yields over 10%. In our view, we expect some of these countries to cut rates later on this year. After the inflows you've mentioned, it sounds like investors have revisited their credit portfolio and the decision to allocate to emerging market debt. How is this interest in allocating to emerging market debt, deferred across institutional investors? And from your perspective, how have institutional investors, EMD mandates, evolved over time? So for many investors, EMD has traditionally been perceived as a tactical investment opportunity. Every time, however, given the growth and improving credit quality of the asset class, as well as the diversification benefit it offers, it is increasingly being considered as a core allocation in investors portfolios. EM economies account for over half global GDP now. It institutional investors' allocations remain modest at around 5% to 7% on average, and we think there is room for this to continue to expand along with the universe. This approach to investing in the asset class does vary though. Some prefer a dedicated building block approach and investing in a specific sub asset class, which is more often hard currency debt, as there is no FX risk involved. Other investors may also have specific rating and country requirements. Other investors may be more flexible, particularly if they don't have in-house expertise. They are happy to make a strategic allocation to EMD, while leaving the asset allocation decisions to us. This often takes a form of a more blended approach, where we have the flexibility to invest across the universe in hard currency debt, local currency sovereigns, corporates, and EMFX as well. Another approach that we've seen in the UK over the last 10 years was for clients to make a broad allocation to a multi asset credit fund that can invest in developed market invested grade credit, high yield, and EMDET, allowing that manager to decide where they see the best value at any point in the cycle. At the Monday, however, we strongly believe that clients should invest in EMDET as a stand-alone asset class, rather than the exposure they may get through a multi asset credit fund. The key reason behind this is that we believe that emerging market fixed income is a research intensive asset class that requires deep expertise and knowledge of different idiosyncratic political, economic, social, and technical stories in order to uncover the most attractive risk award opportunities. The asset class offers attractive alpha potential that is unlikely to be delivered by a generalist credit team managing a multi asset credit portfolio. Accessing EMDET exposure via multi asset credit generally delivers you the beta or market return of the broader asset class, whereas there is significant dispersion across the 70 countries in the universe, which can be exploited to extract further value. Thanks, Serena. Great insights. It's clear that EMD has shifted from being seen as a tactical allocation to a core strategic allocation for some investors. Everybody is aware that investing comes with its risks. Could you please give us an overview of the risks associated with investing in emerging market debt? And how does this compare to other fixed income asset classes? EMDET is often seen as a homogenous asset class with minimal differentiation, but this [BLANK_AUDIO] be further from the truth. There are multiple drivers at the M-depth performance. These include idiosyncratic country factors, politics, and exogenous factors as well, like Fed, ECB rate policy. Political risks are probably more elevated in emerging markets, relative to developed markets, and that's why country selection is key. In terms of liquidity, while this does vary across asset classes, overall liquidity has improved significantly due to a deepening of local markets and greater investor participation in the asset class. EMFX and local currency sovereigns are the most liquid part of the EM-depth universe, and that's followed by external sovereigns and corporates. Some investors may also be concerned about default risks in EM-depth, but as we noted earlier, better fundamentals have led to improving credit quality, and as a result, default rates remain below their historical average in both the sovereign and corporate space. The last sovereign default we saw was in 2023 in Ethiopia, and since then, almost all countries that needed to restructure have done so. Whereas in the corporate universe, defaults are low and expected to be equivalent to developed market rates at around 3%, or could even fall below that level this year, given fundamentals are quite strong. EMFX and local currency sovereigns are the most liquid part of the EM-depth universe. I'm interested to understand how emerging market debt investors translate these risks into action throughout their investment process. What goes into the credit analysis and portfolio construction to help manage some of the risks you've mentioned? So we have a dedicated macro strategy and research team that provides insights to inform portfolio managers regarding wider trends within both emerging markets and development markets. We also benefit from a geopolitical expert who provides her thoughts on key developments globally and potential implications, and it is very helpful to have this insight. We also have an experienced credit analyst team with nearly 20 years of experience, and they are also sector specialists. Many of them are multilingual, which we believe is unique, and it enables them to have a deeper knowledge of local markets. In terms of portfolio construction that you mentioned, we viewed this also as a core component of our invest process. We have dedicated analysts who use our proprietary risk management tools to both calibrate and monitor exposures across our funds. They also use the tool to compile performance attribution reports. These ensure the strategy is constructed to optimize risk-adjusted returns over time, as well as through varying market environments. The tool also integrates a diversification dimension when analyzing risk. It's important to note as well that the portfolio construction team is independent to the portfolio management team that sits alongside them, and they also complement or firm-wide risk management activities as well. Your response shows how much expertise and resources required when investing in emerging market debt, especially in terms of macro views and risks. Before we sign off on this episode, I'm keen to hear how ESG considerations are implemented for EMD. Serena, how can asset managers create a comparative edge when evaluating ESG risks in emerging market debt? There is certainly a growing momentum in emerging economies to enhance and broad in their ESG-related practices and financial products. This supports the significant rule of emerging markets in promoting sustainability, addressing climate change, and encouraging responsible investment. These efforts also continue to drive long-term economic growth and development across emerging economies. We believe it is important to consider both financial and ESG risks and opportunities when analyzing and deciding on potential investments. When evaluating ESG risks and EMD, given the vast number of countries and issuers in the universe, it helps to have access to a large resource pool of ESG analysts and experts who independently evaluate and rate ESG risks. They also actively engage with issuers along with the portfolio managers to identify and flag major ESG issues. As we know, EME issuers are further behind the curve relative development market issuers from an ESG perspective. We also see engagement as a continuous process that is not only results driven but also proactive. And our aim is to influence the activities of an issuer and drive an improvement in their ESG practices. Thank you for your time and your insight today, Serena. And with that, we've reached the end of today's episodes. Clearly, this is a very interesting area that investors and schemes may wish to explore. A few key takeaways from today's discussion. Emerging Market Debt is a large diverse expanding asset class which has three areas of issuance. Investor interest has risen in emerging market debt recently with some shifting to a core strategic allocation to the asset class. Emerging Market Debt investing requires comprehensive understanding of various risk premia and it is essential to have sufficient resource and expertise in evaluating credits. For listeners, if you have any questions on any of the topics covered today, please get in touch with your usual hymns consultant or if easier, feel free to drop any of today's presenters any mail and we would all be happy to help. As we usually do, we'll include links to useful research articles and the show notes accompanying this podcast, which can be found at hymns.co.uk/insights. If you've enjoyed today's podcast, don't forget to follow through your smartphone via Apple podcasts, Spotify, or Amazon to access any future episodes and loads of other great hymns, Robertson content. And with that, all that remains is for me to say a big thank you to Serena and listeners for joining me today on my first podcast hosting gig. Until next time.