By Marco Santamaria
Investors in hard-currency emerging-market (EM) bonds are starting to change the way they think about the opportunity. For some, this means moving to investment-grade-only strategies.
Seeing EM Debt Differently
Historically, investors have made a distinction between sectors: should they own sovereign and quasi-sovereign debt, or corporates? But as the market has evolved, more people have started to think of the market in terms of quality: investment grade (IG) or high yield (HY). Some of them, notably insurance companies, are opting for investment-grade-only strategies.
Thinking of emerging-market debt (EMD) opportunities in terms of credit quality rather than sector makes sense given the dramatic evolution of the opportunity set. In the sovereign/quasi-sovereign sector, for example, credit quality has steadily improved over the past decade. As recently as 2001, just 35% of the J.P. Morgan EMBI Global Diversified index was investment grade. That proportion has now climbed to 62% of the index.
In other words, the risk and return characteristics of traditional sector-driven EMD strategies have changed significantly. Investment-grade EMD—both sovereign and corporate—behaves quite differently from high-yield EMD, as shown in the chart below. Relative to high yield, investment-grade EMD exhibits lower returns, lower volatility of returns, and higher sensitivity to US interest rates. So, as sovereign credit quality has improved over time, investors in a sovereign sector-driven strategy would have seen progressively lower return potential, lower volatility and higher sensitivity to US interest rates than they originally bargained for.
As the chart shows, today there is a great deal more commonality in the behavior of EM securities defined by credit quality than there is by sector. IG sovereign debt has similar risk and return characteristics to IG corporate debt, and the same is true in the high-yield space.
(click to enlarge)The drift in risk and return parameters has, so far, worked in investors’ favor as improving credit quality has generated attractive gains in both sovereign and corporate portfolios. But in a scenario where credit quality is deteriorating, investors could face more risk than expected, driven by the high-yield component of sector-based strategies. It makes sense, therefore, for them to define their strategy along credit-quality lines. Particularly for regulated investors, unexpected shifts in the volatility of returns are undesirable. So insurance companies, for example, have been at the forefront of a proliferation of IG-focused EMD strategies.
Investment-grade EMD strategies can have a number of benefits, including:
- Yield: IG EMD strategies can generate higher yields than traditional developed-market IG strategies, with credit fundamentals that compare favorably to those in many developed markets.
- Diversification: Improved credit quality has made it possible to assemble a reasonably diversified collection of EM sovereign, quasi-sovereign, and corporate issuers. As shown in the chart below, a representative investment-grade portfolio could span almost 40 countries, divided between sovereign and corporate issuers. The total IG EMD universe is nearly US$400 billion.
- Flexibility: Mixing IG sovereign and corporate issuers helps build portfolios that have more flexibility to manage interest-rate risk (the average duration of investment-grade EM corporates is two years shorter than that of IG EM sovereigns).
In conclusion, we expect IG-only strategies to continue to gain favor among regulated and capital-constrained investors. Indeed, bond issuers themselves have taken notice of this demand. In 2012, fully 70% of the EM corporate and sovereign new issue market was of investment grade quality. And we believe the market will continue to create attractive EMD opportunities for ratings-sensitive investors.
Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio managers.
Marco Santamaria is a Portfolio Manager—Emerging Market Debt at AllianceBernstein.