A significant amount of investors bond portfolios are US centric and while there is a robust opportunity set within the domestic sphere, there are drawbacks to holding a 100% US bond portfolio. In this piece we would like to address those issues and to introduce Emerging Market debt(EM), it’s characteristics and a present rationale for an active vs. passive approach.

Drawbacks

The main drawback is that the US Bond portfolio is dollar denominated and while this can be advantageous during times of dollar strength, it does not allow for currency appreciation in other currencies such as the Brazilian real or the Turkish lira for instance.

The second drawback is the limited opportunity set. The US Treasury Bond market does always warrant consideration for investment although the Indonesian Government Bond Market and the Polish Bond Market may deserve investment dollars. If the US High yield market is overvalued, perhaps an examination of High Yield Debt in Latin America would result in a favorable credit investment opportunity.

A third drawback is domestic only diversification. While there are diversification benefits within US debt classes, a more robust opportunity set that includes Emerging Market Debt may allow for additional diversification and avoid over concentration in any one US debt class.

While we believe that Emerging Market Bonds offer potential for a portfolio to help to mitigate some of the drawbacks of a US centric portfolio, we feel it is important to examine the segments of risk and reward.

Main risk and reward areas for EM bonds.

• Credit quality-The sovereign or corporate debt credit rating can increase or decrease the value of a bond based on the issuers ability to pay. This has been a significant tailwind for a number of years as many countries aided by strong EM growth and reasonably well run fiscal and monetary policies have seen the value of their debt appreciate considerably. There are bond appreciation opportunities due to credit upgrades but it may not be as powerful of a tailwind as in the past. Approximately 75% of the EM universe is investment grade so managers will need to look at a larger opportunity set to find credit upgrade potential.

• Duration(interest rate sensitivity)-This has helped a lot of the early participants in the EM debt class maturation process and can be a significant portion of the returns going forward but much more selectively. The emerging market debt indexes have to be dissected and expanded upon in order to continue to have interest rate sensitivity work in the investors favor. While difficult to quantify, we favor managers who are able to delve into the macro picture and invest where there are true “real rates” available. This sounds simple but measuring and gauging future rates of inflation globally is no easy task. Once they find solid real rates of return, the anticipation of course is for overall rates to decline so the bond can appreciate in value.

real rate=nominal rate-inflation

• Currency-This is arguably the most complex portion of this opportunity set. It is subject to supply and demand, interest rates, inflation and perceived monetary policy action in the future. It is also one of the areas that offers the most diversification and return potential and when invested in conjunction with credit and duration can be quite appealing but volatile.

The first portion of this piece focused on the drawbacks of a US only bond portfolio as well as an overview of the main segments of risk and reward within emerging market debt. Next we will compare a broad based US ETF with a couple broad based Emerging Market Exchange Traded Funds(ETFs)

US vs. EM Bond ETFs

I-Shares Core Total US Bond Market-AGG While this indicates that it represents the total bond market, it has a heavy weight in Treasuries and Mortgage Backed Debt. Here are the main characteristics.
• US Investment Grade Bonds
• “A” credit rating overall
• 30 Day SEC yield is 2.20%
• Duration 4.93 yrs
• Treasuries and Mortgage Backed Debt represents over 60% of the index.

While at times there has been merit to owning this instrument, the fact that there is currently around $14billion in assets with this fund is very disconcerting given its current characteristics.

Replacing this with domestic bond managers who specialize in various sectors of the bond market makes sense to garner higher risk adjusted returns and to move out of a treasury based index. We will cover that in another piece but for now will highlight two funds that cover a broad EM Debt market.

I-Shares J.P. Morgan USD Emerging Markets Bond ETF-EMB
• US dollar denominated emerging market debt
• Sovereign bond focus
• “bb” credit rating
• 30 Day SEC yield is 4.96%
• Duration 7.11 yrs
• Reasonably well balanced among the countries represented.

While an investment into this ETF garners a higher yield, it comes with added duration and credit risk as well as an investment denominated in dollars. Also, it is focused mainly on sovereign bonds which leaves out corporate debt. Lastly, the return and diversification benefits due to active currency selection is not available with this fund. It holds approximately $3.6billion in assets which is also disconcerting given the narrow focus in a segment that requires nimbleness. Unless an investor has a high conviction view with respect to $ denominated EM Sovereign Debt, we highly recommend avoiding this product and to sell it and to seek a better instrument.

I-Shares Emerging Markets Local Currency Bond ETF-LEMB
• Non-US dollar denominated emerging market debt
• “bbb” credit rating
• 30 Day SEC yield is 4.90%
• Duration 4.02 yrs
• South Korea and Brazil represent about 30% of the index.
• $611million in assets

Here are the main risks with both these ETFs and with a passive investment into EM Debt in general as we view it at Zenith.

• In the first ETF(EMB) the investor is stuck in dollars and in the second ETF(LEMB), they are stuck outside of dollars. Even if the goal is to be out of dollars with a portion of risk in a portfolio, lack of active selection leaves the investor vulnerable to the current currency weights in the passive basket.
• Credit risk is higher in both and given the complexities of credit research, we would prefer a team that has the time and experience to find value across credit upgrade opportunities as well as overvaluation in downgrade scenarios.
• EM Sovereign debt performance can fall out of favor at the same time that EM investment grade bonds and EM high yield bonds perform well and if they are not part of the underlying basket then that potential is lost.

We acknowledge that they do offer two additional products that represent corporate investment grade and high yield within the emerging market space offering the investor a way to extend beyond the products listed above. Here is the problem. How many investors have the time or resources to actually develop a conviction view on Emerging Market High Yield Debt? We would argue only an advisor who has the time to develop that view should be utilizing this product and then only tactically around a strategic holding with an active manager.

The emerging market debt space is much too dynamic and complex to use an ETF other than for potential tactical purposes and only if you have keen insight into any one of the four mentioned classes. Our rationale is based on the fact that the opportunity set that includes $ and non-$ government debt as well as corporate debt is too disparate to leave to passive management. Even if an ETF were to come out that attempted to gain exposure to the entire opportunity set, would you want passive exposure to Brazilian Industrial Bond exposure coupled with Turkish Government bond?

There are additional ETFs that represent various segments of the EM bond market and all possess their positive aspects as well as their negative ones. While there can be a place for them tactically with a solid understanding of the risk/reward proposition, we believe that an active manager is the best solution to this asset class.

With that in mind, our screens came up with a short list of managers that we feel can add value over a passive ETF. The general qualitative characteristics in an emerging market fund manager include but are not limited to:

• thorough macro economic insight
• defined country and currency selection process
• flexible mandate in order to be able to buy $ or non-dollar debt
• open to a very wide and somewhat unconventional opportunity set
• the past or strong future ability to beat a passive investment
• yields higher than the index with less duration risk

This piece looked specifically at EM Debt which can be a rewarding space to invest although there remains issues of a potential risk-off environment, a global slowdown that hurts EM countries financial ratios and less real rates available over time.

Tom Koehler-CIO

“Emerging Market Debt represents a complex asset class and while we covered a reasonable amount, there is a lot more information needed prior to making an investment decision. Let us know if we can provide more information to help in that process.”

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