Be it in Latin America, Nigeria or Oman, emerging markets provide a broad range of opportunities for credit allocations, says Aaron Grehan, Aviva Investors’ Deputy Head of Emerging Market Debt and Hard Currency Portfolio Manager.
Many view emerging market debt as a volatile asset class and a tactical investment, but the asset class can make strategic sense, Grehan told Investment Magazine’s Market Narratives podcast.
“Emerging market debt is seen as a highly volatile asset class and it doesn’t have to be with the blend of investment grade and high yield. It doesn’t have to be a volatile asset class, it can be managed in a way that’s more defensive,’’ he says
In an effort to generate the higher returns that people expect from emerging market debt, there’s been a bias, from many fund managers, towards higher yielding or lower-rated assets that negates some profiles that can deliver in strong markets but underperform in down markets, Grehan says.
“There’s a lack of consistency from many managers in the universe and a greater beta or element of directional risk that’s taken which we feel can lead to misperception of the asset class and the outcomes attached to it from underlying investors.”
Aviva Investors’ approach looks to a more consistent balance between investment grade and high yielding assets to remove those biases and use the full range of the asset class, such as high quality, to push back against misconceptions and create a more structural allocation.
“We think the asset class, although it has its challenges, its still deserving of a structural allocation and not be used as tactical that many investors are still doing,’’ Grehan says.
He says macroeconomic risks of rising inflation and uncertainty on growth outlook are exaggerated and the outlook seems to be more supportive than the commentary suggests.
“Ultimately we think that supportive conditions will persist for financial markets and that will continue to offer good conditions for emerging market debt assets to perform,’’ he says.
An imminent announcement from the US Federal Reserve to taper bond purchases should not be taken as a hawkish signal, Grehan says.
A much higher interest rate, in the US or globally, is a risk but the current move is transitory and the US central bank is likely to not be forced into reacting and moving forward with interest rate rises.
“We think they will continue to be gradual and patient and focused on growth and supporting the recovery that we find ourselves in,’’ he says.
“With regards to outlook for growth, expectations have cooled from the greater optimism that existed in Q1 of this year but the outlook is still positive, a lower and slower recovery than initially expected but still one that is supportive for financial assets.”
Diversification is key
Emerging market debt as hard currency, both sovereign and corporate, can help investors manage changing macroeconomic conditions by shifting between investment grade and high yield for credit beta, he says.
“In the current environment, a skew towards better quality high yield can protect you from rising rates and offer you something that is more resilient to just an investment grade allocation,’’ Grehan says.
“Then the ability to use investment grade and change your allocation offers you more protection on the downside from growth concerns or a real de-anchoring of the outlook versus just a pure high yield allocation.’’
The risk for emerging markets is if the inflation and interest rate pressures in the US start to build and become more structural, leading to an increase in borrowing costs for all countries that issue in US dollars.
A “double whammy’’ could also occur if growth slows more than expected in China and outperformance in the US leads to upward pressure on interest rates leading to liquidity and insolvency issues for some emerging market borrowers.
“The doomsday or worst case scenario is a growing default rate within our universe as borrowing costs become unsustainable or markets are unopened and countries are unable to finance debt.’’
China’s growth outlook has a bigger impact on the Asian region and commodities but Latin America, although differentiated with some dependence on commodities and China, would benefit from US economic growth.
“Generally speaking a weaker China outlook would have a negative region and commodity exports whereas those countries with closer ties to the US would perform better.”
Grehan says a huge growth in emerging market corporates in the past 10 years has moved some allocation from emerging market debt to stand-alone status in the global credit context.
“Investors need to catch up where the asset class is, perhaps it’s been viewed under a historical lens, rather viewed in the scale, benefits, diversification that it has that it did not offer 8-10 years ago,’’ he says.
Looking to opportunities, countries with lower levels of vulnerability and exposure to near-term debt, with a diversity of funding sources, good local market access, and improvements in policy are in Aviva Investors’ cross hairs.
“Countries that stand out to us at the moment that are offering good risk to reward are Nigeria and Oman, names that might be seen as slightly ‘racy’,’’ Grehan says.
“In the case of Nigeria, you have relatively low debt to GDP, you’ve got low short-term debt so there no risk of liquidity issues, and the benefit of higher oil prices for this and next year,’’ he says.
“That vs yield in the region of 7-8 per cent along the curve offers a great prospect for generating sustainable and low volatility returns.”
Meanwhile Oman is more than an oil credit allocation, he says.
“But we’ve seen a real improvement in policy take place in the last two years. There’s a strong push for reform but there’s strong improvement in the fiscal outlook that’s not driven by oil,’’ Grehan says.
“Factors are positive, it’s a re-rating story that is something that will continue to improve and reverse the credit downgrade that have taken place in the past several years.”