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Volatility Strategies: Navigating Market Fluctuations In Colombia – The premium in emerging market corporate credit is enticing, but investors may be nervous about holding emerging market assets. Many assume that emerging market bonds come with high volatility, increased downgrade and default risk and poor ESG practices. But are these assumptions based in fact?
Spreads for emerging market corporate bonds are significantly higher than in developed markets. We can see this ongoing and large premium available for comparable BB and BBB bonds in the chart below. We would find the same premium in the single A and single B rating bands.
Volatility Strategies: Navigating Market Fluctuations In Colombia
Portantly, EM companies also offer a spread advantage to EM sovereigns. The EM sovereign space, which can offer attractive diversification benefits, offers little spread coverage at maturity and valuations in line with US companies. For that reason, the value proposition is within the EM business space.
Exchange Rate And Foreign Reserves Volatility.
However, many institutional investors remain underweight emerging market debt, given the specialized knowledge required and lack of in-house expertise. For the top 50 US life insurers, for example, the median allocation to emerging market credit is just 2.7%, and that includes exposure to emerging market sovereigns.
One common misperception about emerging market companies is that they are of lower quality, have higher levels of debt and suffer more defaults than their developed market counterparts. In fact, EM companies typically have more conservative balance sheets and historical default rates are on par with developed market peers.
Consider debt levels: In both the investment grade and high yield segments, emerging market companies have well under half the net leverage of US and European companies.
The lower leverage levels often reflect prudent financial management. “Companies in emerging markets have different motivations,” says Elisabeth Colleran, portfolio manager for emerging market debt portfolios at Loomis Sayles. “Unlike companies from developed markets, they tend not to borrow to create the optimal capital structure to drive their share price.”
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Rather, companies from emerging markets usually borrow for productive reasons – to prove and expand plants and mines, or to build ports and telecom towers. “They have a healthy fear of long-term borrowing and the effect on the bottom line,” adds Colleran.
Now let’s examine the idea that standards in emerging markets are high. This idea seems to come from the media attention given to sovereign standards – such as Argentina, Venezuela and Sri Lanka.
Colleran says: In fact, default rates for emerging market high yield bonds over the last 15 years are little different from those of developed markets.
Default risk can be further reduced by shifting to higher quality bonds. Loomis Sayles, an affiliate of Natixis Investment Managers, creates a crippled zone to limit default risk by maintaining an average portfolio rating of no lower than BBB-. “Lower valuations can produce huge returns in risk-on years, but horrible returns in risk-off years,” says Colleran. “We want to avoid that volatility in our returns.”
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Investors wary of emerging markets often cite geopolitical risk and volatility. Both of these risks exist, as Russia and China have demonstrated in 2021 and 2022, although for different reasons. But again, this perception of emerging markets is wrong.
First, media headlines tend to focus on the pact of geopolitical risk on more volatile emerging market stocks and local currencies. Hard currency bonds tell a different story, however, showing a much smoother performance over too, with lower drawdown.
Second, emerging markets are often wrongly portrayed as a unified bloc. “People see the stories about Russia and China and assume that all emerging markets are in bad shape,” says Colleran. “While there are certainly global factors to consider, each emerging market is different; each is in its own phase of the economic cycle, each is uniquely gripped by geopolitical factors, and each has an independent central bank.
The Loomis Sayles Emerging Market Debt team analyzes emerging markets, assessing volatility and returns along the spectrum. By diversifying with around 125-150 issuers, investing only in hard currency bonds and by focusing on high quality names, it will significantly reduce volatility. “In good years for emerging market bonds, we don’t achieve the highest returns,” says Colleran, “but in bad years we should outperform a broader EM credit universe. From positive country and corporate sectors we also expect some capital appreciation.”
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Another way to reduce volatility is to shorten the duration of the portfolio. As rising interest rates have emerged as a significant risk to bond prices, holding shorter dated bonds reduces price volatility.
A strong top-down view of country and sector risk drives portfolio positioning, “This approach has helped us deal with a variety of headwinds, by adjusting commodity exposure, and changing country exposure to geopolitical concerns and opportunities,” says Colleran . “And, from a security selection angle, our analyst team provides deep, forward-thinking security recommendations with the goal of minimizing credit losses.”
Colleran states: “Companies in emerging markets may be more focused on creating positive social change than their Western peers,” says Colleran. Some companies big enough to issue bonds see it as a duty to help build schools and even entire cities. Other companies are increasing financial inclusion by developing processes and apps that allow users to send and receive funds without a formal bank account.
Loomis Sayles began deploying ESG factors at the corporate level 12 years ago and has used a materiality mapping approach for the last several years to help it select and monitor its credit positions.
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With growing ESG expectations from investors and regulators – particularly the SFDR regulations – the data points are expanding and feeding into the fundamental case for investing.
Colleran says: “We had already done a lot of work integrating ESG considerations into our risk analysis, but what SFDR does is force you to be explicit about how you assess and categorize ESG risks, what internal and external transparency proves.”
Short dated credit for emerging markets can be an effective asset for investors who want to raise yield and lower volatility.
Sometimes the approach is used in tandem with faster assets, such as debt in local currency emerging markets. It can also be linked to a high yield allocation. These combinations have the potential to further increase yields without increasing volatility to unacceptable levels.
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Some investors have made the strategy their core bond allocation. As Colleran says, “It has a nice Sharpe ratio, which makes it attractive to a wide range of investors as the basis of their bond allocation.”
This communication is for information only and is intended for investment service providers or other professional clients. The analyzes and opinions referred to herein represent the subjective views of the author as referred to, unless otherwise stated and are subject to change. There can be no assurance that developments will occur as may be predicted in this material.
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See Midyear Outlook: Eve of Disruption? Portfolio strategies offer their views on investor misperceptions, inflation and the Fed’s pause, market wind, and tactical allocation options.Americas Offshore Australia Austria Belgium Brazil Canada Chile China Offshore – 中国境内 China Onshore – 中国境外 Colombia Czech Republic Denmark Dubai (IFC) France Germany Hong Kong – 香港 Hungary Israel Italy Japan – 日本 Korea – 한국 Luxembourg Mexico Netherlands Norway Poland Portugal Saudi Arabia Singapore Slovakia South Africa Spain Sweden Switzerland Taiwan – 台灣 United Kingdom United States Location not listed
Beginning in March 2022, the Federal Reserve (Fed) raised interest rates at the fastest pace since the 1980s. Financial markets are now pricing in for the central bank to be near the end of its walking cycle (Figure 1).
Source: Bloomberg, as of April 24, 2023. FOMC OIS stands for Federal Open Market Committee Overnight Indexed Swap.
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With yields at current levels, bond funds can lock in longer-term returns, offer potential for price appreciation and generally serve as a hedge against a possible hard landing. Although increased cash balances worked during the Fed’s hiking cycle, we believe now is an opportunity for clients to consider adding duration given the potential for a Fed pause.
While investors are not penalized for adding duration early, there is a potential cost to being late (Figure 2). Historically, cash underperforms when the Fed stops hiking (Figure 3).
Figure 2: Act quickly – there are opportunity costs of being late. Core bond yields have fallen quickly as the Fed stops hiking.
Source: Bloomberg, as of March 30, 2023. Time period from 1979-2019. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index
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Source: Morningstar as of April 30, 2023. Represent asset class returns by respective Morningstar categories. Past performance does not guarantee or indicate future results.
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