A more thoughtful approach to emerging market debt - J.P. Morgan Asset Management
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A more thoughtful approach to emerging market debt

Contributor Katherine Magee

Investing in traditional debt-weighted fixed income indices comes with challenges, which can be particularly pronounced in emerging markets. Katherine Magee examines a rules-based approach to address these challenges while still providing a core exposure to the asset class.

Allocating to Emerging Market Debt

Investors are increasingly allocating to emerging market debt, attracted by diversification, higher yields on offer compared to developed market bonds, and the improving credit quality and fiscal strength of many emerging market sovereign issuers. While the asset class was down in 2018, it has rebounded significantly and is one of the strongest performing fixed income asset classes in 2019. Through the end of August 2019, a traditional hard currency sovereign index, the J.P. Morgan EMBI Global Diversified Index, has returned 13.5% year-to-date1.

Yet even in a market rally, emerging market debt investors still face many of the same challenges and concerns that are present throughout the cycle – namely idiosyncratic country risk and unstable credit risk exposure. As an example, in 2019, countries like Argentina and Venezuela have experienced challenges. The debt issued by these individual countries has lost between 35% and 45% of its value year-to-date through August, This has had a negative impact on performance of the market, even as the broader asset class has been positive.

Here we examine systematic ways to improve upon these challenges. The research outlined here 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

Source: J.P. Morgan Asset Management, Bloomberg. JPMorgan EMBI Global Diversified Index as at August 31 2019.

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

Source: J.P. Morgan Chase, J.P. Morgan Asset Management, as at August 31 2019. “Countries Removed by Risk Filter” is comprised of countries removed via the risk screen in the EM Risk-Aware Index. They are cap weighted to illustrate returns and risk. Index inception date: December 31 2009. Indices do not include fees or operating expenses. Past performance is not a reliable indicator of current and future results.

Recent Results: Countries in Crisis

In 2019, even as the broad emerging market debt universe has rallied, this quantitative risk filter has added value. We examine two specific examples: Venezuela and Argentina.

Venezuela has been a dominant story in emerging markets in 2019, driven by political instability, sanctions, and humanitarian challenges. To begin the year, Venezuela made up roughly 1% of the traditional JPM EMBI Global Diversified Index. Yet with a duration-times-spread (DTS) more than three times higher than the next riskiest country, has been consistently screened out by our quantitative risk filter since 2010.

Systematically avoiding this country has improved performance, with USD-denominated debt returning -35.7% year-to-date through August 31 2019. However, this has also come with a few key additional benefits, including:

  • Liquidity: following US sanctions, Venezuelan debt is no longer widely traded so owners of this debt will struggle to find buyers if they look to sell. After evaluating this lack of liquidity, leading index providers like J.P. Morgan have decided to phase Venezuela out of their indices over the course of the year. This means that in order to track the index, traditional passive asset managers may be forced to sell this debt at significantly lower prices.
  • Yield: Venezuela is still included in the headline yield of the standard EMBI Global Diversified Index, despite the fact that the country is in default. For example, as at the end of May 2019, the country made up less than 1% of the index market weight, yet it contributed nearly 10% of the index’s headline yield as Venezuelan debt “yielded” 62%.
  • Volatility: Since Venezuelan debt is not widely traded, for part of the year, indices that included these bonds simply rolled the price on this debt, artificially understating the volatility of the index and not reflecting the underlying market dynamics.

Argentina is another recent example of idiosyncratic country risk having an outsized impact on investor returns in 2019, with USD denominated debt returning -45.5% year-to-date through August.

Following the surprising scale of the defeat of Argentina’s incumbent president Mauricio Macri in the first round of Argentina’s presidential election on the 11th of August, there have been significant and rapid moves in Argentinian assets. This reflects market perceptions of a likely shift towards a less market-friendly policy under a potential new government. Since then, the Argentine Peso has dropped in value by 22% vs. the US Dollar, CDS has widened by 2700bps, and USD-denominated bonds returned -51.5% in the month of August alone.

At the beginning of August, Argentina made up 2.3% of the traditional EMBI Diversified Index, yet has been excluded via our quantitative risk filter for more than nine years. Simply avoiding an allocation to Argentina led to more than 1.2% of outperformance at the index level over a single month in August. This represents another strong illustration of the strategy avoiding some of the idiosyncratic issues associated with the highest risk countries, and thus reducing 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 3 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 3: Historical Credit Rating Breakdown: J.P. Morgan EMBI Global Diversified Index

Source: J.P. Morgan as at August 31 2019

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, for example:

  • 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 and risk/return profile, a standalone quality filter also reduces the strategy’s headline yield, this second step can enhance the yield profile.

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 – are being added to the EMBIG universes and will eventually make up roughly 12% of the standard J.P. Morgan EMBI Diversified Index.

Inclusion of these countries will tilt the EMBI Global Diversified Index more towards investment grade, lowering its yield (with an overall yield-to-worst (YTW) moving from 6.86% as at December 31 to an expected level of 6.59%) and giving investors even more exposure to US rates (duration moving from 6.55 years as at 31 December to an expected level of 6.77 years by the end of the year). Source: J.P. Morgan

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. As an example, while investors have historically considered emerging market debt as a high yield asset class, as of June 2019, the inclusion of the Gulf countries has meant that the unconstrained, debt-weighted J.P. Morgan EMBI Global Index average rating has moved to Investment Grade, based purely on issuance patterns and methodology changes which are completely out of the hands of the investor. To contrast, while these five countries have also been added to the JPM EM Risk Aware Index, our approach has meant that the impact on credit exposure and duration has been smaller.

Bringing it all together

As outlined, gaining exposure to emerging market debt through a traditional passive index fund can be challenging, as debt-weighted benchmarks frequently suffer from unrewarded credit risk concentrations, unstable credit ratings, and fluctuations in duration. In designing the JPMB   strategy, we focus on the investment outcome and use a unique two-step process to improve on these characteristics.

The end result is a core exposure to the hard currency sovereign emerging market debt asset class (the proprietary JP Morgan EM Risk Aware Bond Index has a historical tracking error to a traditional index in the range of 1-1.2%) but with the potential for better risk adjusted returns. Similarly, given the focus both on screening out the highest-risk names and then shifting of the credit allocation towards higher quality high yield, JPMB   has a headline yield and duration that are similar to a traditional index, as illustrated in Chart 4.

Chart 4: J.P. Morgan Emerging Markets Risk-Aware Bond Index Snapshot

Source: J.P. Morgan Asset Management as at August 31 2019. Yield is not guaranteed and may change over time.

Finally, Chart 5 shows returns of the index tracked by JPMB   . Since inception of the J.P. Morgan EMRA Index on December 31, 2009, it has successfully provided a core exposure to the asset class while, generating an improved risk-adjusted return compared to a traditional index.

Chart 5: Year by Year Performance of Smart Beta Index

Source: J.P. Morgan Asset Management, Bloomberg. As at August 31 2019. Index inception date: December 31 2009. Indices do not include fees or operating expenses. Past performance is not a reliable indicator of current and future results.

Conclusion

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.


INVESTMENT OBJECTIVE:

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.

Disclosures:

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.

Indexes:
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.

Related funds

JPMorgan USD Emerging Markets Sovereign Bond ETF (JPMB)

A smarter way to access emerging markets debt.