July-August 2017

EMERGING MARKETS: A persuasive voice

Fran-RodilossoVanEck’s Francis Rodilosso spoke in a webinar about the case for emerging market bonds and how the firm delineates the market. Presented in association with Funds Europe.

Francis Rodilosso, head of fixed income and ETF portfolio management at the fund manager VanEck, is a persuasive advocate for emerging market bonds.

In his Funds Europe webinar, he said that the economic outlook was interesting, with potential policy shifts ahead by central banks in the US, Europe and Japan. In the years since the global financial crisis, these had pursued unprecedented ‘easy money’ policies.

Yet despite much talk recently of interest rates rising, Rodilosso pointed out that between the end of 2015 and the end of May 2017, US treasury yields had barely increased all along the yield curve, except at the very short end and suggested this was indicative of rate hikes the Federal Open Market Committee was pursuing.

Also, over the past 18 months currencies had not moved much against the US dollar, with both emerging market and developed market currencies outperforming the greenback slightly.

Speaking about the currency exposure of the large emerging market bond allocations that have been seen in recent months, Rodilosso said: “I would assume the majority of those investing in emerging market debt are allocating in the hard currency space. It’s the largest in terms of international investor involvement.”

Buckets of bonds
Emerging market bonds cover a very broad category of exposures. They differ by regions, currencies, types of economies and credit profiles.

VanEck views emerging market debt in four buckets: hard currency sovereign debt and hard currency corporate debt are two; local currency sovereigns and local currency corporates the others.

The four have exhibited different riskreturn profiles over time, which is why the firm thinks the universe merits this kind of delineation.

The emerging market corporate bond space has grown to be a significant proportion of the overall emerging market fixed income market, with around $1.4 trillion worth of hard currency corporate bonds making up the indices, the majority of which are investment grade.

Emerging market corporate bonds originate in about 50 different countries and all four main emerging market regions.

Of that roughly $1.4 trillion total for hard currency emerging market corporate debt, corporate high yield accounts for over $400 billion.

The high yield segment makes for a large and diversified market, said Rodilosso, and there is even a higher average credit quality in high yield emerging market corporate bonds than there is in their US equivalents.

Along with higher credit quality, there is also higher yield. At each point along the rating scale, an investor would get paid more to invest in emerging market bonds, Rodilosso said.

The interesting comparisons with the US don’t end there: the indices that cover emerging market high yield corporates have a lower duration than the broad US high yield market. The difference is about half a unit.

Sovereign downgrades
For several years in the hard currency sovereign category, a series of downgrades has occurred, bringing the market’s overall credit rating down.

Today, major indices in emerging market hard currency sovereigns are comprised of less than 50% investment grade bonds with an average credit rating in the high BB range. According to Rodilosso, this higher-quality end of the ratings spectrum presents good opportunities.

There is more uncertainty when it comes to local currency sovereign bonds. At times these bonds have exhibited a very low correlation to US treasury bond yields, and sometimes a higher correlation to equities. But this is by no means always the case. Local currency bonds offer diversification in portfolios alongside treasuries and equities, including emerging market equities.

Local currency emerging market bonds are “a yield play but with currency exposure”, Rodilosso said.

“So we have not been of the opinion that this should be a dominant force in the driver return in a broad diversified portfolio [but] we think [local currency emerging market bonds] plays a meaningful role in adding yield diversification and potential capital appreciation when one has a positive view on emerging markets in general.”

China: a high-quality issuer
During the webinar, Rodilosso focused for a while on China, a country that had recently, in June, been admitted to the MSCI equity index. China’s large debt does come with a large GDP but concerns remain about the country’s shadow banking system, corporate borrowers and state-owned enterprises.

From a sovereign debt perspective, from a ratings agency perspective, and from an ability-to-pay perspective, China is a high-quality issuer, he said.

A big question surrounding China’s inclusion in local indices is the convertibility of the renminbi – and that’s why it will take some time before China is placed in tradable debt indices. Yet China’s overall credit quality would enhance the local currency emerging market bonds index and China already has a decent presence in the hard currency index.

Now that China has made it into the MSCI emerging market equity index, its next step is to get into bond indices.

It won’t achieve this in 2017, Rodilosso said, and may have to wait till after 2018. In today’s climate, investors have legitimate geopolitical risk concerns. Nationalists lead China and the US, he said, and the degree of unpredictability associated with Donald Trump can raise risks. “When making asset allocation choices, geopolitical risks have to rate as an important factor right now.”

Rodilosso also talked about asset allocations to emerging market bonds using ETFs. Rather than be drawn into the debate about active versus passive, he simply said ETFs were another tool for investors to allocate, including to high yield.

The VanEck webinar ‘Fixed Income Solutions: A Case for Emerging Markets Bonds’, took place in June and is available to watch on our webinar channel at www.funds-europe.com/webinar-channel.

©2017 funds europe