With emerging markets (EM) equities, currencies and sovereign debt posting strong year-to-date gains, should investors also warm up to EM corporate credit, which lagged the rally?
Robert Abad: Investors with an interest in EM should always be on the lookout for opportunities in the corporate space. The broad market sell-off since the end of 2014, on the back of the sharp pullback in commodity prices, has re-priced the entire asset class, unearthing a number of value opportunities for the patient and risk-tolerant investor.
However, choosing the right investment vehicle isn’t that easy, as the EM corporate boom of 2010-2014 spawned funds and ETFs of all shapes, sizes and colors. The EM corporate space alone experienced its own ETF mini-boom in 2012 when four debuted within three months of each other.
With this in mind, investors should think carefully about the pros and cons of going with a passive product, which could be a cheaper way to play short-term market momentum, or going with an actively managed product, which could offer investors more total return potential.
Q: What should investors have in mind when considering an EM corporate ETF?
Robert Abad: It’s important to note that no two ETFs are the same. As an example, let’s compare CEMB from iShares and EMCD from SPDRs. On paper, they have similar characteristics in terms of amount of assets under management, country exposure, average credit rating, duration statistics, and expense ratios. Yet, there’s a big performance gap between the two products as of end-March, with EMCD posting a year-to-date gain of 2.4% versus 6.4% for CEMB. Why? The difference can be explained by nuances in portfolio composition and security selection.
For instance, as of end-March, EMCD had a greater concentration in investment grade (IG) credit and, in its top ten holdings, a greater allocation to oil-sensitive, quasi-sovereign paper from Mexico and Brazil – the epicenter of the recent EM storm. CEMB, on the other hand, had a greater mix of issuer and country exposure in its top ten holdings and more exposure to EM financials and high-yield rated credits. As a result of its more diversified portfolio, CEMB posted a smaller drawdown during the broad market sell-off in January and February, and was better positioned to enjoy March’s sharp rebound.
This simple example highlights two key lessons:
1.) EM corporate products that have an investment grade bias may not shield investors from mark-to-market volatility or defaults – risks normally associated with EM “high yield” products. For example, a greater allocation to investment grade credit, such as Petrobras and Pemex in EMCD, generated higher portfolio volatility (almost twice as much as CEMB), resulting in poorer performance over the past six months.
2.) Concepts like “sovereign guarantees” are a great marketing device during bull markets, but once the broader credit cycle turns for the worse, and EM-specific pressures escalate, such “guarantees” can no longer be construed or perceived as insurance policies. One only needs to look at recent events in Brazil and Petrobras to know just how quickly markets and rating agencies will test that thesis.
Q: What other lessons can you share with investors?
Robert Abad: With any passive EM corporate product, try to get a better sense of how the issuer-selection methodology of the underlying benchmark influences the number, size and credit quality of the portfolio’s holdings. This will greatly influence the product’s return and volatility characteristics. In our example, EMCD uses the BofA Merrill Lynch Emerging Markets Diversified Corporate Index (which strips out very low rated and defaulted issuers), while CEMB follows the Morningstar Emerging Markets Corporate Bond Index (which emphasizes issuers with a market capitalization over $500MM). [Note: active EM corporate managers and investment consultants typically use the JP Morgan family of EM corporate indices (CEMBI) given their tenure and familiarity in the marketplace.]
Also, keep your risk management hat on at all times by keeping a close eye on broader EM-specific trends. Case in point: after a year of body blows by the three major rating agencies, the EM asset class now faces the risk of losing its investment grade status – a key selling point for cross-over investors globally. The ramifications of such an event could precipitate more investor outflows, which could further amplify EM market volatility and raise liquidity and default risk across the EM corporate space.
Last, but certainly not least, take stock of how the broad market environment might evolve over the coming weeks and months. Despite the rally across financial markets in Q1, the fundamental global outlook remains ambiguous on expectations of more noise around China, heightened commodity price volatility, potential spikes in geo-political/terrorism-related risk, domestic factors such as the unfolding corruption scandal in Brazil, and risks associated with high frequency economic data and surprise developments such as the “Panama Papers.” All of these factors point to continued headwinds for the global growth recovery which is critical for engendering stability in EM. Given that EM corporates are a leveraged play on this global theme, having a sense of how markets are evolving can help guide your investment timing.
Robert O. Abad is the founder of EM+BRACE, a global advisory and mentorship initiative that came to life in 2015 with the intent of supporting, developing and inspiring the next generation of emerging market professionals and trailblazers. Robert’s professional experience spans 25 years in emerging markets investment research and portfolio management, risk management, product management, start-up business development, and career training and mentorship. He holds a Master’s degree in International Affairs from Columbia University (SIPA), an MBA in Finance from Columbia Business School, and a BS degree from New York University’s Stern School of Business. Robert is an Adjunct Professor of Finance and sits on the Board of Advisors at Claremont University’s Peter F. Drucker and Masatoshi Ito Graduate School of Management. He is also on the Board of Trustees at Sequoyah School in Pasadena, California.