EM debt: yields are back!

Over the past year, Central Banks’ interest rate hikes and the war in Ukraine, led to a significant volatility shock both in emerging and developed markets. Meanwhile, escalating worries of a global recession were stoked by increasing rates, high commodity prices, a slow Chinese economy recovery, and uncertainty about Europe's energy supply.

Indeed, in 2020, bond markets have had their worst bear market since 1929 and this environment has not spared emerging markets. To illustrate, both the external sovereign index (EMBIG) and the local sovereign index (GBI-EM) had one of their worst years since creation. But thanks to this violent shock, the EM world now offers very attractive opportunities for the following reasons:

• The three main drags on emerging markets in 2022 (the Fed, China and the war in Ukraine) are all fading away at different speeds.

• EM debt looks very appealing first because of the high carry in the double-digit territory and also because the inflation and fiscal fundamentals behind them are quite solid given the tight policies following the pandemic.

The advantage of being benchmark agnostic is that you can benefit from the best of both local and external debt. Our flexible mandate hence allowed us to opt out of negative yielding real interest rate countries from local and external debt indexes, such as in Poland, India, Arabian gulf etc. (something that benchmarked funds cannot do).

Furthermore, it is important to be active in terms of duration management. Therefore, we will favour mainly local debt exposure as well as external debt in laggard names such as central European names. In that context, we believe that the early hikers remain interesting, but also some late comers to the hiking cycle could present a good opportunity such as Mexico.

We also favour commodity exporters with relatively high spreads that offer protection against rising rates and benefit from the commodity boom thanks to their export balances (mainly LATAM & Africa). These countries should continue to benefit from higher commodity prices as well as the necessary investments from commodity importing countries to compensate for the lack of production from Russia and Ukraine in the coming months.

Being able to actively manage currencies is not only a real additional performance driver but also an important decorrelation factor. We currently favour the EMEA region (CZK, HUF) and the LATAM region (BRL, CLP, MXN), where we can find high carry opportunities.

In addition, our flexible mandate enables us to adjust the risk of our portfolio by tactically adding or reducing our exposure to hard currencies such as the EUR, USD or JPY in order to take advantage from different FX environments. As an example, over 2022 our EM FX bucket has been a good contributor benefiting from the weak dollar environment.

If you take any random 3-year rolling period (which is the recommended investment horizon for the fund) since the EM debt fund was launched 5.5 years ago (31/07/2017), the fund actually delivered on its dual mandate by delivering positive performance and always beating its reference indicator (local currency bond index), despite two major crises.

Note that the fund also always beats the other EM benchmark of hard currency debt (EMBIG index).