A more thoughtful approach to emerging market debt
Investing in traditional debt-weighted fixed income indices comes with challenges, which can be particularly pronounced in emerging markets. Investment specialist Katherine Magee explains how a smart beta approach can address these challenges to provide a core exposure to the asset class with less downside risk.
Allocating to Emerging Market Debt
Investors are increasingly allocating to emerging market debt, attracted by the additional portfolio diversification that the asset class provides as well as higher yields on offer compared to developed market bonds. In 2019, hard currency emerging market debt was one of the best performing fixed income asset classes, with a traditional benchmark, the J.P. Morgan EMBI Global Diversified Index, returning 15.0% over the year.
Yet even in a bull market, emerging market debt investors face many of the same challenges and concerns that are present throughout the cycle – namely country-specific tail risk and changes in portfolio exposures that are out of their control. As an example, over the past year, countries such as Argentina, Venezuela, and Lebanon have experienced challenges, with debt issued by these countries falling more than 50% over certain periods, even as the broader asset class has been positive.
Here we examine systematic ways to address these challenges. The research outlined underpins the development of a proprietary “smart beta” index – the J.P. Morgan Emerging Market Risk Aware Index (the EMRA Index), which is tracked by the JPMorgan USD Emerging Markets Sovereign Bond ETF (ticker: JPMB ). In developing this index, rather than simply weighting constituents by debt-outstanding, we instead considered the investor’s experience and sought to address a few of key considerations most relevant to them: country-specific risk, credit exposure, and liquidity, while still providing a core exposure to the asset class.
Addressing Country-Specific Risk
When investing in emerging market debt, drawdown and tail risk can at times be substantial. This includes isolated country defaults as well as more systemic crises, where some countries significantly underperform.
In Chart 1, we compare the historical spread-to-worst of the broad EMBI Global Diversified Index with spreads for individual countries during times of stress. As shown, during episodes like the Argentinian Default in 2001, the Ukrainian Debt Crisis in 2015, and the Venezuelan Crises in 2017 and 2019, spreads on debt issued by individual countries can widen significantly and often abruptly. While these spreads often contract after action is taken (for example, a debt restructuring or changes in policy), these periods lead to a significant increase in volatility for investors.
Chart 1: Index Risk versus Individual Countries at Times of Stress
To address this challenge, we consider a quantitative risk filter. We begin with the EMBI Global Diversified Index, a traditional and widely tracked USD-denominated sovereign debt index. Emerging market countries within that index are then ranked according to their relative risk level and the riskiest 10% of the index by market cap is discarded.
In determining relative risk, we use duration-times-spread (DTS) as a metric, which has a number of benefits:
- DTS incorporates both the country’s spread as well as its sensitivity to changes in spread
- DTS is a good forward-looking measure: it provides a good ex-ante spread volatility forecast and successfully identifies the highest risk countries based on both volatility and tail risk
- Using DTS, rather than a more momentum-based measure, ensures that turnover is contained, thereby limiting transaction costs that would be incurred by the end investor and could be significant in emerging markets
To illustrate the benefit of this risk filter in practice, Chart 2 shows the cumulative return of a portfolio invested in the 10% of market cap of the highest risk countries – those countries with the highest DTS. This portfolio is weighted by debt-outstanding and rebalanced semi-annually. We compare this to the returns of the J.P. Morgan EMRA Index. As shown, while the overall returns are similar, the volatility of the highest risk countries is nearly three times as high.
Chart 2: Impact of Country Risk Filter: Growth of 100
Recent Results: Countries in Crisis (New text-update full section)
In 2019 and early 2020, even as the broad emerging market debt universe has rallied, this quantitative risk filter has added value. We examine two specific examples: Argentina and Lebanon.
Argentina was a relatively dominant story in emerging markets in 2019. As shown in Chart 3, from January through to July, the country’s debt returned 12.5%, roughly in line with the broader index. Yet in August, following the surprising scale of the defeat of incumbent president Mauricio Macri in the first round of Argentina’s presidential election, the country’s debt lost more than half its value in one month alone.
At the beginning of August, Argentina made up 2.3% of the traditional EMBI Diversified Index, but thanks to the risk filter was not held by the EMRA Index and was therefore also not held in the JPMB portfolio. Simply avoiding an allocation to Argentina led to a strong outperformance at the index level and a significant reduction in volatility.
Chart 3: Argentina Sovereign Debt: Cumulative Return
Lebanon is another recent example of where the risk filter has been able to add value. The country is undergoing its worst economic crisis in decades, has experienced significant anti-government protests, and is currently seeking assistance from the International Monetary Fund to restructure its debt. While Lebanon was held in the JPMB portfolio throughout 2018, the country was removed by the quantitative risk filter in March 2019. Since then, its debt has fallen more than 50%, as shown in Chart 4.
Chart 4: Lebanon Sovereign Debt: Cumulative Return
The exclusions of Argentina and Lebanon, as well as other crisis countries such as Venezuela, are strong illustrations of how the strategy is able to avoid some of the idiosyncratic issues associated with the highest risk countries, and thus reduce overall portfolio volatility for our clients.
Addressing Credit Risk
Another challenge of investing in traditional, debt-weighted indices is that investors’ exposure is driven entirely by debt issuance patterns, rather than a desired investment outcome. This can lead to unstable credit ratings, unwanted interest rate sensitivity, or concentrations in areas of the market that are under-rewarded – simply because certain countries issue more or less debt.
Chart 5 illustrates this challenge in the hard currency emerging market debt market. In 2008, roughly 65% of the traditional J.P. Morgan EMBI Global Diversified Index was rated high yield. Fast forward to today and about half the index is investment grade. This variation in credit rating has been entirely driven by debt issuance patterns and is out of the control of traditional passive investors.
Chart 5: Historical Credit Rating Breakdown: J.P. Morgan EMBI Global Diversified Index
To help to manage these fluctuations in credit exposure, we consider a credit stabilisation approach. After removing the highest risk countries as described above, we then re-weight the index toward higher quality high yield issuers, seeking to maintain a consistent 75% risk contribution from high yield bonds and a 25% risk contribution from investment grade bonds.
This approach leads to a number of benefits:
- It provides investors with a more thoughtful and consistent exposure to credit and duration
- It aligns risk exposure to higher quality high yield, an area of the market where investors have historically been more compensated
- It provides a yield that is similar to a traditional index. While removing the highest-risk countries improves an investor’s volatility, a standalone quality filter also reduces the strategy&rsquos headline yield. This credit stabilization step can help to enhance the yield profile.
The impact of this step is illustrated in Chart 6, which shows that the EMRA Index is underweight issuers rated CCC and below (the highest risk area of the market), which allows us to take more risk in higher quality high yield names rated BB or B.
Chart 6: Credit Quality Breakdown
Recent Implications: Gulf Countries
Over the course of 2019, five new countries from the Gulf region – Saudi Arabia, Qatar, The United Arab Emirates, Bahrain, and Kuwait – were added to the EMBIG universes and made 13% of the standard J.P. Morgan EMBI Diversified Index at the end of the year. Inclusion of these countries has tilted the EMBI Global Diversified Index more towards investment grade, lowering its yield and giving investors more duration exposure.
There are many reasons for including these countries, whose share of debt has increased significantly over the last three years. That said, this change still has an important impact on investor outcome and the type of risk to which they are exposed.
While investors have historically considered emerging market debt as a high yield asset class, the make-up of the market has changed over time, based purely on issuance patterns and methodology changes that are completely out of the hands of the investor. In JPMB, we can be more thoughtful.
Bringing it all together
As outlined, gaining exposure to emerging market debt through a traditional passive index fund can be challenging. In designing the JPMB strategy, we focus on the investment outcome and use a unique process to address investors’ primary considerations: generating yield and return while avoiding country-specific tail events.
The end result is a core exposure to the hard currency sovereign emerging market debt asset class (the proprietary JP Morgan EMRA Index has a historical tracking error to a traditional index in the range of 1%-1.2%), with a similar level of yield but the potential for better risk-adjusted returns. Chart 7 shows returns of the index tracked by JPMB which has successfully provided a core exposure to the asset class while generating an improved risk-adjusted return compared to a traditional index.
Chart 7: Year by Year Performance of Smart Beta Index
While there are benefits of traditional debt-weighted investing, a number of challenges remain. The JPMorgan USD Emerging Markets Sovereign Bond ETF ( JPMB ) seeks to address some of these challenges – namely country-specific risk, credit exposure, and liquidity – in a systematic and rules-based way to provide a core exposure to USD-denominated Emerging Market Debt.
The Fund aims to provide an exposure to the performance of bonds issued by the governments or quasi-government entities of emerging markets countries globally which are denominated in US Dollars.
Risks Associated with investing
- The value of your investment may fall as well as rise and you may get back less than you originally invested.
- To the extent that the Fund uses financial derivative instruments, the risk profile and the volatility of the Fund may increase. That notwithstanding, the risk profile of the Fund is not expected to significantly deviate from that of the Index as a result of its use of financial derivative instruments.
- The value of debt securities may change significantly depending on economic and interest rate conditions as well as the credit worthiness of the issuer. These risks are typically increased for below investment grade debt securities which may also be subject to higher volatility and lower liquidity than investment grade debt securities. The credit worthiness of unrated debt securities is not measured by reference to an independent credit rating agency.
- Emerging markets may be subject to increased political, regulatory and economic instability, less developed custody and settlement practices, poor transparency and greater financial risks. Emerging market currencies may be subject to volatile price movements. Emerging market and below investment grade debt securities may also be subject to higher volatility and lower liquidity than non-emerging market and investment grade debt securities respectively
- The Fund is not expected to track the performance of the Index at all times with perfect accuracy. The Fund is, however, expected to provide investment results that, before expenses, generally correspond to the price and yield performance of the Index.
Call 1-844-4JPM-ETF or visit www.jpmorganetfs.com to obtain a prospectus. Carefully consider the investment objectives and risks as well as charges and expenses of the ETF before investing. The summary and full prospectuses contain this and other information about the ETF. Read them carefully before investing.
JPMorgan USD Emerging Markets Sovereign Bond ETF (JPMB) RISK SUMMARY:
ETFs are bought and sold at market price (not NAV). Market price returns are based upon the midpoint of the bid/ask spread at 4:00 pm (when NAV is normally determined for most ETFs), and do not represent the returns an investor would receive if shares were traded at other times. Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops. International investing has a greater degree of risk and increased volatility due to political and economic instability of some overseas markets. Changes in currency exchange rates and different accounting and taxation policies outside the U.S. can affect returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and decreased trading volume. Securities rated below investment grade are considered “high yield,” “non investment grade,” “below investment grade,” or “junk bonds.” They generally are rated in the fifth or lower rating categories of Standard & Poor’s and Moody’s Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk. Investments in smaller companies may be riskier, more volatile and more vulnerable to economic, market and industry changes. Diversification may not protect against market loss.
This commentary is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. These views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. The information is not intended to provide, and should not be relied on for, accounting, investment, legal or tax advice. Past performance is no guarantee of future results. Please note that investments in foreign markets are subject to special currency, political and economic risks. The manager seeks to achieve the stated objectives. There can be no guarantee the objectives will be met.
Index returns are for illustrative purposes only. ETFs have fees that reduce their performance; indexes do not. You cannot invest directly in an index. The index, which is comprised of U.S. dollar-denominated sovereign and quasi-sovereign emerging markets debt securities, utilizes a rules-based methodology that filters bonds based on liquidity and country risk, and reallocates risk across investment grade and high yield credit ratings.
The Underlying Index is owned, maintained and calculated by J.P. Morgan Securities LLC (“JPMS” or the “Index Provider”), which selects securities in accordance with the methodology from among the components of the J.P. Morgan Emerging Market Bond Index Global Diversified, which was developed and is maintained by the Index Provider. The adviser licenses the Underlying Index from the Index Provider. The Index Provider and the adviser are both wholly-owned subsidiaries of JPMorgan Chase & Co., a publicly-held financial services holding company.