Emerging Market Retreat-Global bonds part three

Leave a comment

Our last piece on global bonds focused on non-US Treasury ETF instruments in the developed world. The recent sell off in most emerging debt and currency markets requires the attention of investment committees and Zenith Portfolio Strategies. This would not be a major concern except that there is more than one fire out there. Argentina is in a currency crisis, Turkey is in a massive structural crisis that continues to weigh on risk assets and China is feared to be slowing given recent economic numbers. The Ukraine is crumbling amid the fight between Brussels and Vladimir Putin. South Africa is raising rates to shore up its currency although not to the magnitude that Turkey has done in desperation.

We would like to state that we do not know the endgame with respect to this series of shocks however, it is a possibility that the emerging world needs to truly “reset” before this is over. That would include structural reforms that bolster their fiscal and monetary position through means other than a dependence on fickle foreign capital. When investors leave the US and sell the dollar, there is not as high of a chance of an immediate crisis as our dollar market is deep. The Turkish, Argentinian and South African markets are not as liquid or trusted. Also, raising their cost of capital at a time when economic growth is slowing is not a healthy mix even if it supports the currency for a time.

It is against this backdrop that we revisit emerging market products that we do not feel warrant a place in most investor’s portfolio. We began the discussion in our blog back on October 28th, 2013 along with recommendations.

Here are the two ETFs we featured back in October that have performed poorly.

I-Shares Emerging Market Local currency bond ETF (LEMB) -12% 1 yr return

I-Shares J.P. Morgan USD Emerging Market bond ETF (EMB) -10% 1yr return

Three additional products that represent areas of the emerging bond markets.

Wisdom Tree Emerging Markets Local Debt Fund ETF (ELD) -17% 1yr return

I-Shares Emerging Market Corporate Bond ETF (CEMB) -7.97% 1yr return

I-Shares Emerging Market High Yield Bond ETF (EMHY) -12.21% 1yr return

Here are basic performance numbers from three active managers over a 1yr time frame.

Pimco Emerging Market Corporate Debt Fund $ (PEMIX) -7.40% 1yr

TCW Emerging Markets Bond Fund (TGINX) – 9.9% 1yr

Double Line Emerging Markets Income Fund (DBLEX) -6.6% 1 yr

Van Eck Unconstrained Emerging Market Bond Fund (EMBYX) -12% 1 yr

Brief investment return comparison

A passive approach that sought representation in all segments 1 yr ago would have made equal weight placements in $ sovereign debt, local currency sovereign debt, $ EM corporate debt and $ EM high yield debt.

CEMB, EMB, ELD, EMHY are a few of the instruments that can provide this exposure. An equal investment in all four would have produced a return of -11.79% over the last year.

Interestingly, as much as Zenith touts active management in this area of the capital markets, one fund did worse than this combination by a little bit and did not substantiate our thesis while one fund beat the combination handily. That is a huge difference and supports at least in this case, the argument for active management.

Double Line has been much more tilted in favor of the dollar and EM corporate debt and both aided performance while Van Eck has been less prescient as they have a significant portion in sovereign local currency bonds.

This is not an indictment of Van Eck or full support for Double Line but rather a brief illustration that there is active management that can beat passive ETFs at least over this rough 1 yr period. They simply have the discretion to avoid some areas where the risk/reward is not advantageous.

We outline below the basic characteristics of two ETFs mentioned for your review. If you own them, please schedule an investment committee meeting to determine your stance on the funds’ prospects given its holdings and risk to reward characteristics.

Wisdom Tree Emerging Markets Local Debt Fund ETF (ELD)

This ETF holds emerging market country debt denominated in local currency. The Asia region holds 37%, Europe-Middle East and Africa 32% and Latin America 30%. The duration is 4.6 with an SEC yield of 5.45%. This ETF holds approximately $1 billion in assets and should be sold for the following reasons. While the interest rate risk is reasonable for the yield compensation, given the fast moving dynamics of these markets, it lacks necessary nimbleness. There is value in some emerging market bonds in developing countries but it takes a strong team to determine those values amid a crisis type rout.  There was almost no chance that this ETF would have stepped out of the way of the runaway train. You would need an in-depth view on the monetary policies of the major countries’ and regions’ in addition to a clear view on real interest rate value to warrant a purchase.

I-Shares Emerging Market High Yield Bond ETF (EMHY)

This ETF has below investment grade debt in emerging market countries. The top three countries are Turkey, Indonesia and Venezuela. The duration is 5.44 with an SEC 30 day yield of 6.85%. This ETF holds approximately $191 million in assets and should be approached carefully. The interest rate risk is reasonable for the yield compensation although credit conditions need to strengthen and interest rates need to be stable to falling in order for this to work out well. Unless your investment committee has a strong positive view on the return and risk characteristics of this instrument and the underlying country’s monetary policy, currency outlook and credit conditions for the underlying corporate debt, then an active manager would likely be a better option.

Zenith recommends that firms sell any and all of these holdings. The portfolios are positioned in very specific and difficult areas of the capital market. Our solution is to vet high quality managers with a risk mitigation process in place.

Our next piece will make recommendations with regard to global and emerging market managers worthy of consideration for your investment portfolio.

Sincerely,

Tom Koehler, CIO

“Bond markets represent a complex asset class and while we covered a small 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.”

Emerging Market Local Currency Bonds

Leave a comment

In this piece, Zenith examines a few issues with regard to the local currency emerging market bond asset class for portfolio managers. Investment committees and advisors who are currently in this space or who are contemplating a potential placement should consider these factors.

This asset class has been in a structural upturn over the last few years due in part, to improving balance sheets and relatively high real yields. The middle class of these countries has strengthened although it is a struggle for many as the gap between rich and poor persists.

Initially the Emerging Market Countries, (EMC) story consisted of the “BRIC” countries that include Brazil,Russia,India and China, however, it is now expanding to include South Korea, Indonesia and Turkey among others.  Many of these countries have a different set of yield curves and varied monetary and fiscal policy.

Most of these countries has the ability to issue bonds in their own currency to better reflect the economic reality in their own country. This local currency bond market created a new opportunity set for investors.  Credit upgrades, currency appreciation and high real yields offered a “risk to reward” that was too appealing to pass up for investors. All of these factors are not as strong as in the past; although, a selective investment to Emerging Market Debt (EMD) can continue to be an additive component to a portfolio.

Benefits:

  • Expanding opportunity set as more countries develop their debt markets and corporations obtain funding through their own currencies.
  • Participation in the Emerging Market Growth (EMG) potential with potentially less volatility than equities.
  • Under allocation in many institutions asset allocations may allow for an allocation lift in valuations.

Negatives:

  • The Emerging Market world continues to suffer from political unrest and in some cases a slow evolution to democracy.
  • Hot money trade
  • Some Emerging markets are extremely dependant on commodity markets.
  • Less true real yield opportunities

Local currency bonds such as Brazilian Debt issued in the “Real” is seen as a way to diversify away from the dollar and garner a better yield. The sources of return and risk should be dissected.

A. Currency appreciation:

This is one portion that is taken as a given by much of the investment community. The belief is that the dollar is headed down and so the simplistic assumption is that Emerging Market Currencies will hedge the portfolio. The problem with that is EMC; while generally growing faster than the United States, all have currency issues to deal with especially those with fragile export sectors. This portion of the return expectation should be tempered and managed carefully.

B. Duration:

This is difficult to assess as each yield curve in the world has various segments that are more attractive than others. We do not believe that a broad based “Beta Bet” will work in today’s environment since the opportunity set needs careful examination from a seasoned manager.

C. Credit:

This has been a positive driver of returns over the last few years as many EMC’s have been upgraded. Potential for upgrades remain, however in a slowing global economy, this “asset class” return potential should also be tempered. Given the complexities of sovereign debt credit analysis, we recommend a placement with an astute manager.

D. Risk-on trade:

This “asset class” does not perform well in a risk averse environment; therefore, it’s diversification benefits may be muted at a time that a portfolio needs a non-correlated asset class.

It is important to understand the rationale behind a placement in this asset class is just as important, whether the strategy is actively or passively managed.  One needs to determine if the placement is a tactical or strategic move.

It is difficult to make a strong case for a strategic placement that is passively managed as the currency and debt markets are too dynamic to leave to a passive strategy.

While Emerging Market bond and currency exposure also makes sense to a degree, the specific risk is very high. A comprehensive global bond portfolio with active currency management adds significantly more potential alpha and portfolio Sharpe enhancing qualities.

LEMB

I-Shares-Emerging Markets Local Currency Bond Fund

Sec 30 Day Yield 5.23%

Duration 4.11

Rated BBB

Country Weights

South Korea21.74%

Brazil12.11%

Mexico7.15%

EMLC

Market Vectors Emerging Market Local Currency Bond ETF

SEC 30 Day yield 5.56%

Duration 4.89

Country Weights

Poland9.97%

Malaysia9.52%

Turkey9.49%

South Africa9.11%

Brazil8.98 % 5.15%

ELD

Wisdom Tree Emerging Markets Local Debt Fund

SEC 30 Day yield 4.57%

Duration 4.48

Country Weights

Malaysia10.39%

Mexico10.28%

Indonesia10.28%

Brazil9.99%  5.15%

Since these ETFs are paid in US dollars, the yield minus the current US CPI is an appropriate gauge of the real yield. Since the US CPI is approximately 2.7%, the real yield carry is over 2% for all of these ETFs.

That carry is not free; however, the differential can be wiped out very easily by currency movements. Unless your firm has a clear conviction on the forward looking basket of currencies versus the U.S. dollar in any of these instruments, Zenith recommends that these funds be avoided.