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:
). 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
JPMorgan USD Emerging Markets Sovereign Bond ETF (JPMB)