Despite having an amazingly complex brain, how much of our day do we spend not using it and simply glide through on autopilot? For example, we don’t notice how often we check our phones, we commonly tune out of conversations that fail to engage us and we regularly start filling in the gaps, when things do not make sense, rather than actively questioning why we might not understand. Let’s look at an example.
How many f’s are there in the following sentence?
Finished files are the result of years of scientific study combined with the experience of years.
Most people count two or three (in the words finished, files and scientific), but there are actually 6 f’s. Did you find all six? If you are stumped, most people fail to count the fs in the word of (three times). It just does not register, because many of us do not process the word "of" as a complex word, and the f sound in of is pronounced more like a "v" sound (ov).
Taking another example – for those readers currently working in an office – how many of you would be able to state where your closest fire extinguisher is located? Researchers have found most people either do not know or failed to notice (or did not care). It might be right down the hall, or outside the door – most have seen it hundreds of times, but it simply does not register. Interestingly, in this study, the same researchers varied the experiment and, rather than tell the office worker where the extinguisher was, they asked them to find it. They often failed, however, here is the good news: first failing to find it, and then actually finding it (combined with the embarrassment at realising the worker had passed by the extinguisher every day) led to good memory of the location, when tested three months later.
Is there something investors might have missed?
A fire extinguisher could save your life, but as we rarely need them, we habitually ignore them. We often overlook things, usually because of a perception they do not matter too much and/or our mind helps us fill in perceived gaps – leading us to think we know more than we know. More often than not this is inconsequential, but every now and again it can prove costly.
In the world of investments, we believe there is an asset class which is all too often overlooked and one which many investors routinely fill in the gaps, leaving them to simply not notice what has been going on. This asset class is emerging market debt (EMD).
Depth, quality and an attractive yield
There is a commonly held, but misplaced, belief that EMD is an obscure, risky, outpost of the fixed income universe, which has resulted in it being under-represented in many portfolios. According to a recent report* published by Ashmore Investment Management Limited, using data from the Bank of International Settlements, the global bond market expanded by $6.2trn in 2019 to reach $117.9trn. Developed economies have issued $88.3trn of bonds, or 75% of all the world’s current total. In economic terms, the bond markets in developed countries represent 171% of developed market GDP. The EMD market measures $29.6trn, or 25% of the global bond market. The market, which comprises both government and corporate bonds, is equivalent to 85% of EM GDP.
The key takeaway from this analysis – notwithstanding the lower debt/GDP ratio of emerging economies versus developed – is the sheer size of the EMD market. It has grown by more than 7 times since 2004, when it measured ‘just’ $4.3trn. Despite this, many investors carry very little exposure to the asset class and it is commonplace to find portfolios with no money allocated to EMD at all. Equally noteworthy over this period is the steady growth of local currency markets. As detailed in the table below, these markets have grown to a size of $24.2trn, compared to $3.0trn in 2004.
Source: Ashmore, BIS, IMF. Data as at end 2019
As local markets become more advanced, Ashmore highlight in their report that countries generally turn to domestic financing options. Even so, EM external debt (the portion of a country's debt that is not issued in their domestic currency) grows every year and now measures $5.5trn, up from $4.9trn in 2018. However, the share of external debt in total EMD has fallen from 32% in 2004 to 18%, as of the end of 2019. In other words, more and more EM countries are self-financing – we suspect the fact this is in excess of 80% of total borrowing, will come as a surprise to many.
When investors think about emerging markets, they typically think about growth as a key parameter for successful investing. This notion is most applicable to the equity markets, whereas in the world of fixed income, the first priority is to ensure that cash flow generation is not impaired. In other words, can the debt be serviced and will the debt be repaid? Some investors will be surprised to learn over 75% of EMD local currency bonds are rated investment grade. Moreover, the average yield is circa 4.5% on 10 year bonds. With interest rates close to, or below, zero across much of the developed world, this is very attractive.
Bond yields (10 yr)
Source: JP Morgan Asset Management, September 2020
What about diversification?
EMD offers a widely diversified opportunity set across geographies, currencies, industry sectors, credit quality and maturity. At the country level, issuance is dominated by the big five – China, Brazil, South Korea, India and Mexico. EM corporate investment grade credit is a diverse asset class encompassing the world’s largest banks, such as ICBC and Bank of China; the largest resource companies, such as Vale and Saudi Aramco, as well as the largest internet companies in the world, including Alibaba, Baidu, and Tencent. These companies are not only extraordinary businesses, but also strategic for the countries from which they originate, thus providing a double layer of credit risk protection.
Debt or equities?
Performance of EM Equities vs EM Government Debt (Local Currency)
Perhaps even more surprising than the scale of EMD markets, is their relative performance compared with their equity peers. As the chart above illustrates, on an absolute, as well as risk adjusted basis, bond investors have faired considerably better over the long-term.
Not without risk
However, things can and do go wrong and debt restructuring, particularly in the sovereign issuer space, attracts attention. Argentina, for example, has once again been forced to renegotiate terms with its creditors in 2020 and the deteriorating economic and political landscape in Lebanon points to a rising risk of default. Notwithstanding this, it is generally in a sovereign issuer's best interests to reach a benign settlement agreement with lenders. Investors can also be comforted by the multilateral support a sovereign issuer is likely to receive in order to improve current and future debt sustainability.
When default risk is elevated, markets typically over-react and bond prices fall precipitously to distressed levels. Each example will, of course, have its own associated risks, but in these circumstance attractive opportunities may emerge. A case in point is “Venny” bonds (aka those issued by Venezuela), currently trading at 8 cents on the dollar – the lowest level for a sovereign since the 1930s. The distressed pricing is driven by a dire economic outlook, exacerbated by Trump sanctions. Biden, if elected, could choose to lift these, which would likely see the bonds double or even triple. However, it would take a brave investor to put this trade on now.
How to invest
We advocate an active, flexible and blended approach to EMD investing, accessing both local and hard currency debt, to fully realise the yield and diversification potential available within the asset class. In our view, this approach enables flexibility to rotate into sectors and geographies that offer the most attractive compensation for risk and critically, avoid those where the current price fails to reflect the deteriorating credit profile.
We firmly believe this is an asset class worth noticing and having brought it to your attention – in much the same way the experimenters described earlier did with fire extinguishers – we hope it is something to remember. EMD will not save your life – but we suspect ignoring it could prove costly for long term investors.
Please do contact us with any questions.
* The EM fixed income universe version 9.0, August 2020
Julia Warrander and Russell Waite
Click here for printable version.