Q&A: Investing in Emerging Markets Debt

Emerging markets, or EM, debt took a dual hit in 2020 with the COVID-19 pandemic and sharp decline in oil prices.

The double blow has caused U.S.-dollar-denominated EM debt to lag the U.S. bond market in returning to pre-pandemic levels. But widening EM credit spreads indicate that investors are being rewarded with a yield premium for the heightened risk of investing in these bonds.

Taking a blanket index approach to EM debt, however, may not be the most profitable way to go. The pandemic created idiosyncratic risks within the EM debt markets that make certain countries more promising bets than others.

To learn more about the state of EM debt and where advisors can seek the best opportunities, we spoke with Marcelo Assalin, portfolio manager of the William Blair Emerging Markets Debt Fund (ticker: WEDRX) and head of the emerging markets debt team at William Blair. Here are edited excerpts from that interview.

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How was the emerging markets debt landscape impacted by the pandemic?

Initially, EM debt credit spreads widened, and bond prices fell, as the severity of the pandemic led to strict containment measures around the world, creating significant concerns about the potential impact on the global economy.

After a short period of high volatility, EM debt started to gradually recover following unprecedented policy responses — fiscal and monetary — in developed and emerging economies.

Strong support from multilateral organizations such as the International Monetary Fund, the World Bank and the G-20, amid very ample global liquidity conditions, helped EM debt prices to reach pre-pandemic levels by early September 2020. Later in the year, the recovery gained momentum as COVID-19 vaccination programs started to be rolled out in advanced economies, raising prospects for a sharp global economic recovery.

[Read: Q&A: How Financial Advisors Talk About Cryptocurrency With Clients.]

You mention the pandemic created idiosyncratic risks and diverging prospects across the emerging markets. Can you explain what these risks and prospects are?

The severe economic impact from the pandemic led to credit deterioration across the asset class. Collapsing economic growth impacted fiscal revenues, which in turn led to higher levels of debt. Countries with stronger credit fundamentals, the ability to implement fiscal and monetary stimulus, easier access to financing and strong relationships with multilateral and bilateral lenders have been in a better position to weather the impacts of the pandemic.

Overall, countries preserved their ability to continue servicing their debt. However, we did see a handful of countries with fragile credit fundamentals where the pandemic accelerated debt restructuring processes.

Debt sustainability remains an important concern in a few places, but many of these bonds are already trading at distressed levels. And we believe that in almost every case, recovery values are likely to be higher than what the market is currently pricing.

How should financial advisors address these risks and prospects when structuring client portfolios?

Emerging markets debt is an asset class that lends itself to active management. Idiosyncratic risks and diverging prospects create ample opportunities for alpha generation.

However, it’s critical to select an active investment manager with a proven ability to navigate through these risks and opportunities, with a strong focus on risk management and diversification.

[Read: 5 Tactical Investing Methods for Advisors.]

Why should advisors incorporate emerging markets debt in a client’s portfolio?

EM debt has the potential to improve the risk-return profile of a client’s fixed-income portfolio. It has historically displayed low default rates and high recovery values.

The asset class has evolved materially over the years, and today, is comprised of more than 900 issuers from over 90 countries, representing more than a quarter of the global fixed-income market.

At the same time, EM debt is still underowned and underrepresented. Institutional investors remain underallocated to EM debt, and the asset class remains underrepresented in global fixed-income indices. In turn, the asset class is undervalued in our view, and the risk-premium overcompensates investors for volatility, default and loss-given-default risks.

Where should financial advisors be looking for the best opportunities in emerging markets debt today?

We believe EM sovereign and corporate credit debt denominated in hard currency, such as the U.S. dollar, offer attractive value to investors.

While market conditions normalized as prospects for the asset class improved, credit spreads remain above long-term averages, especially in the higher yielding part of the investable universe, where implied probabilities of credit default are overstated in our view.

Zambia is a country that clearly was suffering from debt sustainability risks ahead of the pandemic, whereby the impact of COVID-19 clearly accelerated the debt-restructuring process. Bond prices have moved much closer to where we believe recovery values are in recent weeks, following a positive outcome in the general elections. Sri Lanka and Ecuador bonds continue to trade at distressed levels. In both cases, the outlook remains highly uncertain, but we see opportunity in this space.

What are your predictions for the EM debt market going forward?

A positive combination of improving global growth and favorable liquidity conditions will continue supporting investor sentiment throughout the rest of the year. Across emerging markets, credit fundamentals should continue to recover amid improving economic growth, rising global trade and higher commodity prices.

While we believe U.S. Treasury yields should remain the main headwind for EM debt returns over the near future. We see limited scope for a significant increase in yields. We anticipate the continuation of extraordinary monetary policy accommodation in the United States as concerns about rising inflationary pressures will be mitigated by a slow recovery in employment.

In our opinion, technical conditions should also remain supported by positive investor flows, contained new net debt issuance, and strong inflows from nondedicated, crossover investors attracted by favorable valuations of EM debt relative to developed-market credit.

Emerging markets debt hard currency valuations remain attractive, especially in the high-yield space, where credit spreads remain above long-term averages. These valuations are particularly attractive relative to U.S. high-yield corporate credit. We believe the risk premiums in EM debt hard currency sovereign credit overcompensate investors for default and loss-given-default risks.

Overall, we see scope for EM debt risk premiums compression, and we expect tighter credit spreads to partly offset marginally higher U.S. Treasury yields in the coming months.

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Q&A: Investing in Emerging Markets Debt originally appeared on usnews.com

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