GMO, the $66 billion asset manager co-founded by Jeremy Grantham in 1977, has long had sharp research on various topics, such as clean energy stocks and the impact of passive investing on markets. In a recent report about emerging-market debt, 30 years after the firm started investing in it, the manager argues that it should be a permanent part of portfolios.
“Because the credit spread for risky assets like EM credit and [high-yield credit] generally overcompensate an investor for actual credit losses, an ‘always on’ allocation, either via dedicated mandates or via multi-sector credit strategies, is warranted,” GMO says.
For a long time, hard-currency sovereign and quasi-sovereign debt and U.S. corporate high-yield debt performed similarly. But lately, corporate high-yield has been more attractive to investors. “Unprecedented U.S. pandemic stimulus, coupled with creative alternative financing sources in private credit markets for U.S. corporate high yield borrowers, has perhaps shifted the default cycle from public high yield to private markets,” GMO said.
Meanwhile, sovereign emerging-market debt has been less appealing in recent years. The pandemic caused an uptick in sovereign debt defaults and interest rate hikes were particularly damaging to the securities in 2022 because of their longer duration. Local-currency sovereign debt and emerging-market corporate debt, which already had lower returns, looked even worse after defaults in China’s property sector.
After a “roaring start 20 years ago,” the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) index “bounced around below its 2012 high-water mark! So why make a distinct allocation to EMD at all? Why not simply select a broader mandate (perhaps multi-sector fixed income or multi-asset credit) and let the manager decide when and how to allocate?” the report asks.
GMO argues that it’s time to invest in emerging market debt because pandemic- and war-related defaults have passed. The firm also expects hard-currency debt to return to its pre-pandemic pattern of excess returns. Additionally, after a decade, valuations of the local-currency debt now warrant opportunistic investments for the medium-term and even frontier local debt has emerged as a potentially diversifying area for allocation.
Self-servingly, of course, GMO also argues that the inefficiencies associated with emerging-market debt mean it will remain a place where managers can deliver alpha for a long time. Considering that, GMO called it “curious” that some allocators would choose passive ETFs to get exposure to emerging-market debt, which GMO says typically underperform the benchmarks.
“For now, the main conclusion is that hard and local currency EMD is a place with demonstrated high alpha potential, which we believe itself can be a reason to allocate,” the report says.
