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Unlocking markets: the rich tapestry of EM Debt
Anthony Kettle, EM Debt Senior Portfolio Manager, and Mike Reed, Head of Global Financial Institutions, discuss how a ‘one size fits all’ approach doesn’t work for the emerging markets debt universe. Key talking points include the diverse mix of countries and sectors, why certain headwinds of the last few years could be turning into tailwinds, the more positive aspects of Trump’s agenda, and the need for a well-resourced team in order to deliver alpha when investing in EMD.
Unlocking markets: the rich tapestry of EM Debt
By Anthony Kettle, EM Debt Senior Portfolio Manager, and Mike Reed, Head of Global Financial Institutions.
Mike Reed: 00:04
Hello, and welcome back to Unlocking Markets, the RBC BlueBay podcast, where we bring you experts from across our firm, providing opinions on markets, global policy, and macroeconomics, whilst highlighting how these feed into our investment decisions. I'm Mike Reed, Head of Global Financial Institutions. Today, I'm delighted to welcome Anthony Kettle, who is Managing Director and Senior Portfolio Manager within the Emerging Markets Fixed Income team here at RBC BlueBay.
Anthony, there is so much for us to talk about when it comes to emerging markets, so I'm really looking forward to hearing your views and thoughts on the opportunities that exist for investors in the coming year.
Anthony Kettle: 00:44
Hello, Mike.
Mike Reed: 00:45
Well, let's kick off. I'd like to ask you why, with so many opportunities available in developed markets, should investors actually be bothered spending time researching emerging markets? How significant are they in a global context?
Anthony Kettle: 00:59
Yes, it's a good starting point, because we often have the challenge from home bias from investors in the US or Europe; why should they step in and have a look at emerging markets?
Firstly, I would say it's the size of the asset class. If you think about what emerging markets actually is, you have debt that is issued in hard currencies, so US dollars or euros. You have debt that is issued in the local currencies of these particular countries, like Brazil, for example.
The universe size of hard currency assets is about USD4 trillion, and that compares to an asset class like US high yield, which is about USD1 trillion. It's almost four times the size in emerging markets. If you look at the local currency, that issuance size is in the region of USD20 trillion, so multiple sizes larger than US high yield. Not only do you get a very large asset class, what you also get is access to a very diversified set of economies. Because when we call ‘emerging markets’ that term, we're talking about more than 80 different countries spread across the world.
Also, in terms of sectors, we have 13 different sectors and growing by the day. I would also say the average rating of the asset class, which is BBB, if we look at some parts, for example, the local markets, or BB rated in the hard currency or the credit world; a reasonably highly rated asset class, which provides you a large amount of diversification.
I would make the point that it's also an asset class which has inherent inefficiencies, because we have the issue of it being a very diversified asset class. A lot of investors don't really track the asset class as closely as they do in the developed markets, for example. There's just an inherent level of inefficiency within the asset class, which ultimately leads to it being rich in alpha.
Mike Reed: 03:02
I hear you; these are large asset classes. I get the point on diversification, that's obviously very important within portfolios. But I guess the very term ‘emerging’ conjures up thoughts to many of high risk and, I guess, that would be potentially big losses. Is it reasonable for investors to think of emerging market bond markets in this context? Maybe give me some clues on how returns have actually fared over recent years compared to developed markets.
Anthony Kettle: 03:32
I would say, actually, the asset class has been in existence for quite some time. We have a lot of good data going back to the early 2000s. If we look at return data from say, 2003, up until present day, return per unit of risk actually within the emerging markets fixed income world stacks up reasonably favourably versus what you find in the developed markets. It's certainly, in the hard currency world, on a par with the developed markets. In local markets, it's a little bit different in terms of the way we would look at things.
The key message really is that over a long period of time, return per unit of risk has been pretty similar within the emerging markets as compared to developed markets. However, over the last five years, it is true to say, emerging markets have been impacted by quite a few different themes. I would say firstly, Covid was a big hit to emerging markets. I would say that we also had the Chinese de-leveraging story in quick succession following Covid, which impacted the emerging market performance.
Then we also had the Russia and Ukraine conflict, which created a reasonably high level of defaults as well. We saw particular underperformance within emerging markets in 2022. However, what all of the confluence of events really created was a mini credit cycle in emerging markets. We experienced a reasonably high level of default. Coming out of that, we now have a very different asset class, which has de-levered quite a lot. Fundamentally, it looks reasonably strong. Actually, that was evidenced in the performance of the high yield part of our corporate asset class, for example, last year, which was one of the outperformers.
I think a lot of the issues which impacted EM over the last five years and were negatives are almost turning into tailwinds because during Covid, emerging markets took on a lot less debt than developed markets. The Russia-Ukraine war perhaps is moving towards some sort of resolution. And in terms of the Chinese deleveraging, a lot of the pain has now been taken, particularly in the real estate market. We're reasonably close to coming out the other side of that. We can see that there are some tailwinds to emerging market performance on a look-forward basis.
Mike Reed: 06:06
There are a number of issues there. I think one big issue that we obviously can't go too far without talking about is the 300-pound gorilla in the room at the moment that is President Trump. The new president has made it clear that he sees tariffs as a legitimate policy in both trade negotiations, as well as in achieving other aims. If we step back from the rhetoric, how much of a risk is this over the coming 12 months for investors? Does this going to lead to another wave of downgrades and defaults as you saw back in the Covid era?
Anthony Kettle: 06:42
It's a really interesting one because people assume that Trump ultimately and his policies will be negative for emerging markets. I think what people fail to realise is how many different countries there are within emerging markets. It's very difficult to paint the entire asset class with one broad brushstroke.
If you think about Trump's agenda, the deregulation agenda ultimately is positive for risk assets, just more broadly. If you think about the deglobalisation and the trade and the tariffs, that is the part of the policy mix which is ultimately risk-negative, but not just for the emerging markets. If you think the primary target perhaps of the tariffs and the trade side, maybe China, but China has been preparing for this for many years and is now reasonably resilient to the tariff agenda.
What it may be actually is that parts of the developed markets are potentially more susceptible to the trade and the tariff agenda because they're a bit less prepared for it. However, what we're seeing is tariffs are a negotiating strategy here for Trump. If they are implemented, they basically will be negative for risk more broadly.
There are parts of his agenda that actually are proving to be more constructive for the emerging markets. I would say, first and foremost, it has been really the geopolitical side because we have a truce at the moment, or a ceasefire in the Middle East, which has allowed for the reopening of some shipping lanes. It's allowed for potentially slightly lower levels of inflation. Importantly, it has just de-escalated one of the major conflicts in the world at this point in time.
We also have potential for talks to begin around some sort of peace deal for Russia and Ukraine. If you think about some of the assets in our world, Ukrainian assets, for example, if we ultimately come out with some sort of ceasefire and peace deal, that could be quite constructive for Ukrainian assets. It could be quite constructive for assets within Central and Eastern Europe as well. There are some positive sides to this agenda that can help the emerging markets.
I would also say that the immigration agenda, where Trump is looking at deportations often back to emerging market countries, that necessitates emerging market countries actually allowing these planes to land and taking immigrants back into these countries. So in doing so, it provides some leverage for the emerging market countries themselves to negotiate with Trump. There are many different parts to the policy mix here. I would say in terms of the key message, there's differentiation. There are winners and losers out of this agenda, and it's very hard to paint EM with one broad brushstroke.
Mike Reed: 09:50
I think you've anticipated my next question here, because what I want to talk about is how can people capitalise on some of this volatility, the changes in agenda, and the volatility that's going through. We don't generally talk about specific products in this podcast, but I'm aware that you and your team run a very successful hedge fund that focuses purely on emerging market credit. I'd love to hear your thoughts on how you, first of all, identify opportunities and what differentiates an EM credit fund from other alternative strategies that exist out there in the mainstream.
Anthony Kettle: 10:30
I think the differentiator here is that you've got an extremely large universe, but you're looking not only at bottom-up fundamentals, but you're also trying to assess a lot of geopolitical risk, a lot of political risk, a lot of event risk, because you are looking across 80 different countries, as well as trying to analyse all of the fundamentals. Often, every year, there will be, unfortunately, some conflicts in the world, there'll be many different elections. They provide opportunity, but you have to be, or have, a team which is well-resourced enough to be able to fully cover that universe.
If you want to cover 80 different countries and 500 different corporates, you need to have a very well-resourced team. Often that is the obstacle stopping people running these sorts of products because by their very nature, they are capacity-constrained, high-return type products. To identify the opportunity, really, it is a matter of having the experience within the team. It's having a very structured process in terms of being able to actually just identify what opportunities are actually likely to be able to deliver alpha for the strategy.
I think very importantly, not limiting yourself to only looking at the long side of this asset class, because although risk-adjusted returns have been pretty good over the years, there are certainly times with spikes in defaults. There are certainly times where you see increases in volatility, and if you can capture those really through the short leg, that can be a really, really powerful way to diversify your returns, but also protect and even make money when markets are going through those volatile periods. There's no perfect solution to it, but I think it really is time in the market, it is the breadth of the team, and really just the experience of the team that really helps with running a product like this.
Mike Reed: 12:34
Well, thanks for that insight. I know it's been a successful strategy for you for many years, and it's just very interesting because it is very different from a lot of the mainstream long-short funds that we see out there in the alternatives space.
Coming back more to some of your mainstream, more long only type strategies, the RBC BlueBay Emerging Market Fixed Income team, you have a variety of fund offerings across government, hard currency, corporate, and local currency funds. It would be interesting, given a lot of that we discussed earlier, to get your take on the outlook for each of these areas one by one, the main three. The various dynamics that you think are going to impact them over the next 6, 12, 18 months.
Anthony Kettle: 13:18
Yes, absolutely. Perhaps if I start with corporates. In the corporate side of the asset class, the default rate over the last five years has been high, and that's been partly because of the Russia-Ukraine conflict, partly because of Covid. It necessitated some defaults in some of the more levered structures, as well as in China, where there was a lot of leverage and the government deliberately has tried to de-lever, but that has come through, in many cases, default. We saw an elevated level of defaults as compared to developed markets.
However, over the last 12 months or so, what we've seen is a huge normalisation in that trend. Our weakest credits have effectively restructured and de-levered, and we're now left with a universe which is much cleaner. It has de-levered by almost half, so leverage has dropped from around about three turns to about one and a half. It sits well below where developed markets leverage is for the same rating, and yet valuations still look attractive in a relative context.
Our all-in levels of yield look pretty good when we compare them to other very similar asset classes. We've turned more constructive on corporates, I would say; particular parts of the high yield world in emerging market corporate look quite attractive, and particularly in a relative context. We think fundamentals stack up quite well there, and we're constructive on that product.
In terms of sovereigns, when we look at hard currency sovereign debt, it has been an area of interest for investors over the last couple of years because of the large underperformance in 2022, so people chasing the sort of mean reversion. I would say that it remains an attractive part of the emerging markets fixed income landscape. We expect that defaults are actually going to be pretty close to zero this year in emerging market sovereigns. They've had a similar dynamic to corporates where you've had a relatively high level of default for the last, say, three or four years. However, last year it normalised very much, where we had a 0% default rate last year, and we think a very similar thing for this year. What that means is you can really harvest the dollar yields in the asset class, which are quite high. At the moment, they're around about 8%, but depending on whichever rating category you look at, you can look for yields which are upwards of 10% in parts of the asset class. When you have a very minimal level of default, it's a pretty attractive level of return that you're likely to achieve. We still like the sovereign asset class.
I would say in local markets, they are a little bit more at the mercy of headlines because naturally you would expect that FX will adjust with trade. If you have big tariffs that are implemented on certain countries, the natural thing you would expect is that FX would weaken to offset the impact of some of those tariffs. It's difficult to assess right now, because it's very difficult to assess the full extent of the US trade agenda at this point in time.
But what we can say in support of local markets is emerging market countries were very quick to realise the inflation problem back in 2022, very quick to hike interest rates and bring inflation under control. However, that then coincided with the US beginning to hike interest rates. Because we haven't seen a full normalisation yet of the US interest rate policy, we still have very high levels of nominal interest rates in the emerging markets, as well as very high levels of real interest rates because inflation has normalised quite a bit in the emerging markets. We do think that acts as quite a strong buffer to the return profile. It should help with FX markets where you can earn a lot of that carry. Over time, when the Fed begins ultimately to normalise monetary policy and bring interest rates down, that will provide quite a lot of room for emerging market central banks to normalise their own monetary policy rates and cut interest rates.
Mike Reed: 17:55
That was great. I think you're great to get your perspective on emerging market credit. I think given the size, the diversity that's available there, you've made a compelling case for investors to focus on the entity class within their portfolios. Thank you.
Anthony Kettle: 18:12
Thank you, Mike.
Mike Reed: 18:14
Well, many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. Next time on the show, we will be joined by Habib Subjally, Head of our Global Equities team. There'll be a whole world of topics to cover then. If you wish to listen to any of the previous editions of the Unlocking Markets podcast, they're available on our website, www.bluebay.com, or can be found on Apple, Spotify, or Google. Thank you once again for joining us today. Good luck and goodbye.
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