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
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, 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.
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.