This article examines the benefits of actively managing emerging market sovereign debt and some of the arguments around this space.

The following article poses the question: does active management pay when trying to make money in emerging market sovereign debt? In this age of so much “passive investing”, this article considers the case for active control of a portfolio. 

The article is by Cem Karacadag, who is head of Barings’ emerging markets sovereign debt group. He is the lead portfolio manager for the emerging markets sovereign debt strategy and backup portfolio manager for the firm’s emerging markets local debt strategy and blended total return strategy. The usual editorial disclaimers apply; the editors here are grateful to be able to share these insights and invite readers to respond. Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

While general market conditions for emerging markets debt (EMD) - conventionally known as market beta - may be the main driver of EMD returns over short time horizons (days or weeks), idiosyncratic country fundamentals and risks ultimately drive prices and performance over the long term. As a result, there is sizable dispersion in the total returns on the debt of 70+ emerging market sovereigns in the JP Morgan EMBI Global Diversified (EMBIGD) bond index.

In the first three quarters of 2019, for instance, the EMBIGD returned 12.9 per cent. While the great majority of EM sovereigns generated positive returns, some countries’ debt returned significantly more than others’. Eleven sovereigns outperformed the index by more than five percentage points in total return, and 10 sovereigns underperformed the index by more than five percentage points in total return (FIGURE 1). On an absolute basis, while “only” four countries generated negative returns during this period, three of them fell sharply. Lebanon returned -10 per cent, Argentina returned -37 per cent, and Venezuela returned -57 per cent. 

Performance data for three years through 30 September 2019 paints a similar picture. In the past three years, the EMBIGD returned 14.4 per cent. Once again, the vast majority of sovereign debt delivered positive returns, but some countries much more so than others. Seventeen sovereigns outperformed the index by more than 10 percentage points in total return (FIGURE 2). And once again, on an absolute basis, Lebanon (-11 per cent), Argentina (-46 per cent), and Venezuela (-78 per cent) fell precipitously.

 
SOURCE: JP Morgan. As of 30 September, 2019.

SOURCE: J.P. Morgan. As of 30 September, 2019.  

The moral of the story is simple yet powerful: country selection matters and matters a lot. Selecting the right countries requires active management and an investment process that seeks to pick the right apples, and avoid the bad apples in the basket. Similarly, a specific country’s sovereign debt should never be bought just because it is in the index, or without a full understanding of the risks and whether or not potential returns compensate for the risks. A remarkable - and unusual - feature of EM sovereign debt performance over the past few years is that investment grade-rated sovereigns have delivered higher returns than high yield-rated sovereigns. This is partly because of the longer-duration bonds of the former, but it also highlights the importance of discriminating among countries, especially high yield sovereigns.

A few selective comments on some of the best and worst performing countries:

Argentina has been one of the most difficult emerging market sovereigns to analyse and forecast in recent years: President Mauricio Macri won an historic election in 2015, effectively ending Kirchnerism, and embarked on a macroeconomic stabilisation programme with heavy reliance on market financing and subsequently an IMF programme. In the end, the pain of adjustment led to Argentina’s traditionally populist electorate delivering an unexpected and heavy defeat to President Macri in the primary elections this past August. Barings’ EMD sovereign strategies were moderately overweight going into the primary elections, but have since moved Argentina to underweight.

Lebanon’s financial challenges, including a high fiscal deficit and high debt burden, have been well known for a long time, but the country’s repayment capacity has been supported by non-resident (Lebanese) deposit inflows. The sustainability of these inflows, in our view, has always been unforecastable and potentially reversible in response to challenging domestic and regional politics. Barings’ EMD sovereign strategies have not had any exposure to Lebanon in recent years.

Venezuela’s financial challenges have also been well known for many years, yet its future has been difficult to forecast and analyse without visibility on the potential timing and nature of a regime change. Venezuela’s very sizable contribution to index returns for many years made it tempting to invest in, especially before its sovereign default in early 2018. Over the years, Barings’ EMD sovereign strategies have had very minimal exposure to Venezuela and have had zero exposure for the period 1.5 years before its default until the present time.

Several sub-investment grade EM countries generated meaningfully higher returns than the index in 2019 and in the past three years, but each one of them is a unique and complicated story that, in our view, required in-depth analysis and high conviction to invest and stay invested in, even during periods of volatility. Barings EMD sovereign strategies have had exposure to Ghana, Angola, Ecuador, Ukraine, El Salvador, Armenia and Brazil, among the top performers, over the past three years.

In addition to choosing not to invest in several countries in the index, the Barings team has invested, and exploited value, in several countries that are not in the index, among them Albania and Macedonia. This points to the potential benefits of broadening the opportunity set beyond the index and selecting the right opportunities rather than just those that happen to be in the index.
 
Where do we go from here? Are there generalisations we can and should make about EM sovereign debt? Yes and no.

While EM Sovereign BBB spreads are near their tightest levels versus US. Treasuries in the last 10 years (FIGURE 3), we see good value in several EM investment grade sovereigns, including Mexico, Colombia, Indonesia, Romania and Russia.

Conversely, the spread between high yield sovereigns and investment grade sovereigns - as measured by the difference between the EMBIGD 75th percentile spread and EMBIGD 25th percentile spread - is approaching the widest level of its decade-long range (FIGURE 4). Does that mean we should pile into high yield sovereigns?

Our answer is decidedly “no”. While our proprietary investment process and sovereign default probabilities indicate that the spreads on most EM sovereigns (over) compensate for actual default risk, the margin of uncertainty for cumulative probabilities of default over time varies from country to country, as does our conviction in the credit trend.

Hence, while we can comfortably speak to the potential benefits and high merits of investing in EMD, picking the right countries and securities is everything, in our view.