Emerging market (EM) fixed income has grown over the past two decades. EM bonds are issued by EM-domiciled corporate, sovereign and quasi-sovereign entities and can be issued in local and ‘hard’ (typically dollar) currency. JP Morgan’s global EM indices, which capture the investible section of EM markets, have increased from about $350bn in 2002 to nearly $2.5trn by the end of 2018.
- Systematic investment models have been commonplace in equity markets
- Can they generate returns in emerging market debt?
While systematic strategies have been commonplace in equities and more prevalent in some fixed income markets, emerging market hard currency debt markets have so far been a frontier.
Our research seeks to answer two questions. Can a systematic approach generate positive excess of benchmark returns in this market? And, how diversifying can a systematic approach be to the prevailing discretionary approaches? Our analyses provide affirmation for both.
Our focus is on hard currency bonds issued by emerging sovereign and quasi-sovereign entities. These bonds have two sources of risk. First, they inherit exposure to interest-rate risk from the currency they are issued in. Second, they contain exposure to a unique source of credit risk, and hence return. The credit risk for these hard currency bonds is the potential inability to service the foreign currency obligations from locally generated cash flows. This ‘credit risk’ component is our focus.
For our systematic investment themes we built on academic and practitioner literature. This has documented pervasive evidence of associations between measures of carry, defensive, momentum and value and future excess returns across asset classes. Our first aim is to introduce simple, intuitive measures of these themes anchored to the credit risk embedded in EM bonds.
Carry is the tendency for higher-yielding assets to outperform lower-yielding assets if the discount and hazard rate curves remain unchanged. A simple measure of carry is the spread of the respective EM hard currency bond.
Defensive is the tendency of safer, lower-risk assets to deliver higher risk-adjusted returns relative to their low-quality, higher-risk counterparts. We use two measures. First, a measure of sovereign quality as indicated by its ability to achieve low, and stable, levels of inflation, which is an indicator of higher quality macroeconomic risk management by the sovereign. Our second measure is designed to capture the ability to service debt, similar to a debt/earnings ratio. Our ‘earnings’ value for the sovereign combines measures of GDP and expected GDP growth, and our ‘debt’ value sums government external debt and 50% of non-government external debt. The inclusion of the latter reflects that some external private sector debt may be assumed by the sovereign in the event of default.
Momentum is the tendency for an asset’s recent performance to continue, leading to outperformance of recent winners relative to recent losers. We measure momentum as an equally-weighted combination of six-month trailing EM credit default swap (CDS) returns, six-month trailing FX returns, and six-month trailing country equity returns. The combined measure drives a preference for positive CDS returns, local currency returns relative to dollars, and country equity returns.
Lastly, value is the tendency for relatively cheap assets to outperform relatively expensive assets on a risk-adjusted basis. A cheap EM bond or CDS contract is one where the credit spread is wide relative to fundamental credit risk. To construct our value measure, we regress credit spreads onto credit ratings and equity volatility, with the residual serving as our value measure. Using credit ratings and a market-based volatility estimate helps ensure we capture the essential ingredients of distance to default, leverage and volatility.
The figure plots the cumulative returns for a long-only portfolio targeting exposure to these four investment themes, using a liquid subset of EM bonds within the JP Morgan Emerging Market Bond index, as well as the cumulative benchmark returns. This suggests it may be possible to build a long-only EM bond portfolio seeking exposure to systematic investment themes.
We examined the returns of 64 long-only active EM managers with an explicit emerging markets bond index from 2004 to 2018. We find the average active EM manager generated risk-adjusted returns, with an excess of benchmark return of 0.8% and an information ratio of 0.36. However, we find traditional risk premia, specifically passive exposures to EM local currency debt and EM corporate debt, explain more than half of the aggregate and individual manager returns.
The tendency of active EM managers to deliver passive traditional risk premia exposure has implications for asset owners in understanding the nature of excess benchmark returns. That is particularly the case for broader asset allocation decisions and fee discussions.
For each EM bond fund, we computed the correlation of excess benchmark returns to these traditional risk premia. The results show a correlation, with an average of 0.36 to traditional premia. A consequence of this hidden beta is an increase in individual managers’ correlations of excess returns to one other. The average correlation is 0.52, suggesting the commonality in hidden beta reduces the diversification benefit of allocating across EM bond funds.
In contrast, the hypothetical systematic long-only portfolio exhibits a negative 0.2 correlation with traditional premia, and negative 0.06 correlations to other EM bond funds. Therefore, the potential diversification benefits from a systematic approach becomes apparent.
Why this is important now? Markets have seen unprecedented levels of volatility and repricing of risky assets, and EM debt is no exception. As the dust settles, it will be interesting to see how exposure to credit risk has impacted the active returns of EM bond allocations. Times of market stress can help identify the diversifying potential of systematic investment approaches owing to their minimal exposure to traditional market risk premia.
Jordan Brooks is principal and co-head of fixed income, Scott Richardson is principal and co-head of fixed income and Zhikai Xu, managing director of AQR Capital Management