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:
). 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)