Introduction to Emerging Markets Investment Grade Bonds
FRAN RODILOSSO: Emerging markets (EM) debt had over the last several years, leading up to early 2016 at the least, struggled as an asset class. Technically there were outflows from various parts of the EM debt universe. From a performance point of view, EM countries were suffering from lower commodity prices and a stronger dollar, which forced assets out of some emerging markets. It also caused some financial difficulties; current account deficits were ballooning in certain countries and those countries had to make adjustments, which meant weaker currencies and perceived weaker fundamentals.
Interestingly, coming into 2016, what were headwinds for EM suddenly turned into tailwinds. We've had a pause, stall, or end to the dollar rally, depending on your opinion. We’ve also had higher commodity prices associated with that development. We’ve seen fundamentals actually turn in some emerging markets. In other words, growth differentials between emerging markets and developed markets (DM) started to swing back in favor of emerging markets overall.
Emerging markets throughout recent history have grown much more rapidly than developed markets, but that differential had been converging for several years. The EM to DM growth differential is an important fundamental to keep in mind, especially when talking about debt because growth is the best way to finance debt in some respects.
BUTCHER: There appear to have been fairly strong inflows into emerging markets debt since about February of this year. What's that about?
RODILOSSO: Some of the improving fundamentals within EM relative to developed markets, e.g., the weaker dollar, have been important factors. Additionally, we've seen in 2016 another move lower in developed market rates. Much of what kept people away from EM debt asset classes during the previous two years were concerns about higher rates. You’ve had the Fed going at a slower pace and perhaps no pace at all for the rest of 2016. You've had the Brexit. Now you have $11.5 trillion worth of negative-yielding debt in developed markets. You've got a huge percentage of the Barclay's Agg. (Barclays US Aggregate Bond Index) trading below one percent. There are few yield solutions out there for investors.
Emerging markets, now as a longstanding asset class or group of asset classes, particularly the dollar sovereign space, can appear relatively attractive. As a result of some of the declining fundamentals over the previous several years, the emerging markets dollar bond universe that had been as much as 70% investment grade on the sovereign side, suddenly became closer to 50% investment grade. That is what led to some of the thinking around VanEck Vectors™ EM Investment Grade + BB Rated USD Sovereign Bond ETF (IGEM).You’ve seen inflows into dollar sovereigns, local sovereigns, and corporates in emerging markets, and they each offer different risk-reward characteristics. The dollar sovereigns haven’t offered as much yield as local or as corporates, but they have offered lower volatility, particularly in the investment grade space.
BUTCHER: Why do you think it makes sense to focus primarily on investment grade sovereigns?
RODILOSSO: Some investors have been tripped up by some of the downgrades and performance of some of the more volatile lower rated EM countries, such as Venezuela, where there are very real concerns about potential default in the near future. I think these factors have changed the view on an asset class many investors saw as mostly investment grade. Therefore, an investment grade dollar sovereign product appears to be attractive and appears to fill a need in the space.
BUTCHER: Where do you see IGEM fitting in an investor's portfolio?
RODILOSSO: IGEM may potentially be of interest to dollar-based investors or global fixed income investors who have a credit allocation. When you think of credit allocation, the first thing you think of is investment grade or developed market investment grade credit. EM investment grade sovereigns tend to offer a pickup in yield over the investment grade corporate space. Historically, it has been around 50 basis points and sometimes more. It’s also fairly liquid and adds diversification to the portfolio.
For quality credit investors, we think an investment grade sovereign dollar product within EM potentially offers additional yield and diversification. Many traditional EM investors have become increasingly attracted to the asset class over the last decade due to the increased credit quality, which has been due to the fact that many emerging markets have righted their ships. The wave of downgrades that included some very important countries like Brazil and Russia, but probably more importantly, the highly volatile countries like Venezuela, have negatively impacted the perception of a broad allocation to EM.
EM is not a single asset class; there's much differentiation in terms of credit quality throughout. By isolating the higher quality end of the spectrum, we believe IGEM now presents a tool for those investors who are more comfortable with EM as a partial quality trade, not just a more speculative credit investment.
BUTCHER: Thank you.
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