Asset managers have talked about the investment opportunities in emerging market equities, private equity, and U.S. investment-grade credit. But some managers say that something else needs to be on the list: emerging market debt.
Emerging markets are vulnerable to extended rate hikes by the Federal Reserve and to a rising U.S. dollar, which “adds to the burden of hard-currency-denominated debt and tightens financial conditions,” UBS Global Wealth Management said in a March note. But U.S. banking turmoil and signs of a weaker economy suggest that future rate hikes will be smaller — and that other central banks will be more likely to make smaller hikes or pause them.
“We expect volatility to be a continued theme in the short term as the market (and the Fed) remains largely data dependent and macro uncertainty abounds in the U.S. in the wake of the regional bank situation and its potential implications on the economy,” Gramercy Funds Management, a $5 billion firm focused on emerging markets, said in a recent note. “In such an uncertain external environment, active management is critical to managing the risks posed to portfolios and to harness the opportunities that may arise from any dislocations.”
Despite the uncertainty and impact that rising rates abroad could have, emerging markets, including fixed income, might nevertheless be entering a new era of outperformance.
According to Carlos de Sousa, an emerging markets strategist and portfolio manager at Vontobel Asset Management, there are debt opportunities throughout Latin America, if you know where to look for them. Some countries have good fundamentals, while others are highly indebted, and there are both hard-currency debt and local currency securities to consider, de Sousa said.
He likes local currency bonds in Brazil for a few reasons. First, he explained, Brazil’s economic cycle can be a good guide for what is likely to happen in the rest of the world six to 12 months down the road. Vontobel thinks that Brazil will be one of the first central banks to begin cutting rates later this year, so bondholders will likely see capital gains when interest rates begin declining. The double-digit carry of Brazil’s domestic bonds is “not easy to beat,” and the currency’s value remains attractive.
“Politics remain the only caveat, so this is not a country where you buy and hold — it’s necessary to remain active to profit from the added volatility,” de Sousa said. “The debate about potentially increasing the inflation target rate poses risk to the trade, but this has already been priced in.”
When it comes to external debt — that is, money borrowed from foreign lenders — de Sousa said his favorite country is the Bahamas. The wealthy, tourism-dependent nation was hit especially hard by the Covid-19 pandemic, he said, but it has fully recovered and tourist arrivals have reached an all-time high.
“The Bahamas is a country that doesn’t get the attention it deserves because it’s not in the JP Morgan EMBIG diversified index, simply because it’s too rich [and] its GDP per capita is too high to be classified as an EM,” de Sousa said. “[But] its bonds still offer double-digit yields in U.S. dollars, and its government has been implementing a successful fiscal adjustment to gradually reduce excessive public debt incurred during the pandemic.”
Harry Phinney, investment director of emerging market debt at Capital Group, said he is approaching emerging markets cautiously but that “fundamentals are decent across a number of larger issuers and starting yield levels are high, which provides a buffer against broader market volatility.” Phinney is favoring local currency markets, particularly in Latin America, where aggressive rate hikes have begun to curtail inflation, he said.
“Within the [investment grade] universe, we find the steep curves in Middle Eastern countries with high reserves attractive. Indonesia combines strong fundamentals with attractive valuations. Romania became more attractive in January after it covered most of its financing needs for the year,” said Cathy Hepworth, head of emerging markets debt at PGIM Fixed Income.
Hepworth said PGIM’s largest exposures are in BB-rated securities, including debt from the Dominican Republic and Serbia. Both have likely covered their financing needs earlier this year, she said. There is also value in sovereign bonds from Colombia, Morocco, and Brazil — “all solid issuers that can perform well in various environments,” she said.
Elections in Colombia, Argentina, and Turkey could also lead to more investment opportunities this year, according to several managers.
J.P. Morgan Asset Management anticipates that a mild global recession will still occur, and that it will lead to 10 percent to 15 percent returns for emerging market debt in 2023.
“Our core asset allocation view is to rebuild long duration, expressed through EM local and sovereign debt and EM corporate credit. In all these areas, we want to engage with a bias for quality,” Pierre-Yves Bareau, CIO of the emerging market debt team at JPMAM, said in a research note. The firm is using low-volatility currency options and futures to hedge against fatter tails happening more frequently in emerging debt.
