Higher interest rates and a stronger US dollar have driven a sell-off in emerging markets debt that began in April, but opportunities can be found when looking beyond the recent volatility, says Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.
The firm recently reduced the TER on its VanEck Vectors JP Morgan EM Local Currency Bond UCITS ETF, 0.42 per cent to 0.30 per cent, making it to date, the EM local currency bond UCITS ETF with the lowest cost.
“There has been a lot of volatility in emerging markets in recent weeks,” says Rodilosso. “This has been reflected in negative currency returns, higher yields and outflows which is not unusual for the EM asset classes in volatile periods.”
During times of turbulence, emerging markets yields tend to move higher, which is the opposite of what tends to happen in the US, where buying treasuries is the ‘flight to quality trade,’” he explains. “The market demands more yield for risk in emerging markets,” he adds.
Rodilosso’s team at VanEck is responsible for managing approximately USD13 billion through 19 ETFs in the US and Europe, across a wide variety of investment options.
Rodilosso explains that the current environment of steady global growth and generally healthy fundamentals in many emerging markets is typically supportive of the asset class, particularly bonds denominated in local currencies, despite the recent volatility and sell-off in some of the more vulnerable countries.
He points out that there has been higher growth in emerging markets. “But the countries that are running pretty significant fiscal and/or current account deficits are paying the price right now. There can still be a high degree of volatility when a country is not performing well economically or there is political turbulence.”
“The potential for diversification is also attractive,” he says. “Local currency exposure provides lower correlation with Treasuries, versus bonds denominated in US dollars.”
Rodilosso notes that emerging markets sovereign issuers have increasingly issued debt in their local currencies. “The majority of emerging market debt is now denominated in local currencies compared to 20 years ago when a larger share of sovereign debt was denominated in hard currencies, which resulted in various emerging markets crises,” Rodilosso says. “The growth of the local currency debt market has been very positive, and one result is that countries’ balance sheets are not as exposed to external shocks as their external liabilities are a lot lower relative to GDP.”
Rodilosso also noted the relative value of dollar denominated corporate emerging market debt, which tends to pay higher yields within the same industry and for a given credit rating versus developed market counterparts.
“The yield pickup found in emerging markets high yield corporate debt is not achieved by going lower in credit quality,” he says. “Because of the emerging markets label, investors demand more yield for similarly rated credits.” Based on market indexes, the result is a higher overall yield in emerging markets corporates versus US high yield, but with a higher average credit rating. The duration is also lower, which can be attractive in a rising interest rate environment.
“The point is that there is no single story in emerging markets. People see that in equities, but even in debt markets, there are really several asset classes that can behave differently,” he says. “Emerging markets debt ETF offerings have proliferated, because it is a big diversified universe, which is one of its most attractive features.”