Total Return in Emerging Markets Debt
TCW Emerging Markets Income Fund
P. Foley, D. Robbins, A. Stanojevic
Author: Ticker Magazine
Last Update: Feb 02, 10:31 AM EST
|Understanding the development process in each of a strategy’s target markets is crucial for identifying turning points before they actually happen. The fundamentals-based approach of the TCW Emerging Markets Income Fund’s team, relying in large part on primary research, enables it to assess these opportunities at an early stage and position accordingly.
“While we are benchmark aware, our primary focus in portfolio construction is to identify the best risk-reward investment ideas within the country and factor weightings determined by our fundamental research.”
This is why we believe our strategy has been successful. When you examine the totality of the opportunities in a country, it gives you the flexibility to choose the best ideas within each market.
Q: Would you cite an example of an investment in corporate debt?
Petrobras, the state-owned oil company in Brazil, is one example. In late 2014, there were allegations of corruption at Petrobras and other Brazilian corporates involving major politicians. Petrobras spreads over the Brazilian sovereign widened out to close to 800 bps from a pre-crisis level of 100 bps. At the same time, sovereign spreads over Treasuries also widened as the growth potential for an already struggling economy declined.
Petrobras started to trade as if it were going to default. We felt that as a critical state-owned company, the Brazilian banks would serve as a backstop, if absolutely needed. Furthermore, and importantly, we saw the potential for fundamentals to improve, suggesting that spreads were mispriced. We believed that the market was ignoring the fact that the company’s new management team would take appropriate measures to ensure financial liquidity and longer term viability through, for example, asset sales and a reduction in capital spending. We scaled into our position, and it became one of our larger drivers of outperformance in 2015 and 2016.
Q: How have emerging markets changed over the years?
The MSCI Emerging Markets Index used to be comprised largely of commodities, telecoms and banks. Now, approximately one-third is in IT. Asia is an important part of this growth, China in particular. As countries move up the value chain, they diversify their economies and the investable sectors expand.
In the 1998 crisis, close to 100% of external sovereign debt was denominated in dollars, and the bulk was in Latin America. Today, with the growth in local market, about 75% of sovereign debt is denominated in local currency. And the number of countries has increased to 67, with Africa the fastest growing segment of the index.
Also coming out of the 1998 crisis, many countries moved from fixed to floating exchange rate systems, giving policymakers the flexibility to let their currencies fluctuate to maintain the competitiveness of their export sectors. In the 1990s, they were forced to pursue pro-cyclical policies and borrow to fund ever increasing current account deficits. In the 2013-2016 period, on the other hand, they were able to improve current account deficits through FX adjustments while at the same time keeping external borrowings under control.
Q: How do you define and manage risk?
We manage credit risk, interest rate risk, and political risk. The security-by-security scenario analysis is an important part of our risk management; for each investment idea, we isolate strengths and weaknesses and create base-case, upside and downside outcomes. We also focus on diversification, whether by country, issuer, sector, etc. Liquidity is key, and we manage position sizes and tend to pass on smaller new issues that do not meet the minimum size requirements of the index. We actively hedge portfolio and individual-security risk, using a range of hedging tools, including CDS and currency forwards/options.
We sit down weekly to discuss performance attribution by sector (hard currency sovereigns, corporates and local currency). Our goal is to better understand the drivers of performance, what we may have missed, and determine how we may want to reposition the portfolio.
Q: What is your view on the varying policies in developing economies?
Policymakers are similar everywhere – emerging and developed economies. Populist candidates, such as Hugo Chavez in Venezuela or Kirchner in Argentina, will last as long as they can but, ultimately, the imbalances they create work against them and changes inevitably occur. These changes typically offer investors interesting alpha generating opportunities (the so-called turning points we talked about earlier).
Q: What is your outlook on Emerging Markets debt?
We are constructive on Emerging Markets in light of improving fundamentals, attractive relative value versus developed markets and supportive technicals. The synchronous global growth story continues, which directly benefits Emerging Markets through improved trade and a stronger commodity price environment. In addition, the growth story has been broad-based, rather than concentrated in a small number of countries.
Growth potential for EM sovereigns is also significantly ahead of developed markets with the spread between EM and developed market (DM) growth likely to increase for the second year in a row. With average yields of 5-6% (and the potential to capture more in select markets), valuations remain attractive versus developed markets, particularly considering that close to 60% of global fixed income trades below 2%.
Furthermore, most investors remain underweight EM. We expect technicals to remain supportive in light of this underweight, and continue to see investor interest to add exposure to the asset class.
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