By Hamlin Lovell, NordicInvestor

Navigating Tapering, Rate Hikes and Defaults

Abundant liquidity and economic recovery have contributed to a broad-based rally across emerging market debt since March 2020 but investors are starting to become more discriminating: some more interest rate sensitive, and local currency paper has recently lagged and defaults included a large one in Chinese property.

Alejandro Arevalo, Fund Manager of Jupiter’s Global Emerging Markets Debt strategies, still sees broad value in the asset class: “in absolute terms it is fair value. In relative terms, it is the cheapest in five years versus US high yield of the same duration and credit rating. And crises have remained contained in individual countries”. Nonetheless, he is selective in terms of both sub-asset classes and picking individual countries and companies.

Asset allocation is emphasising hard currency, high yield, and corporate debt, and underweighting or avoiding local currency, investment grade and sovereign debt, with weightings varying between fund mandates. Even the sovereign debt fund is holding its maximum allowed 20% weighting in corporates, and the blended fund has ca. 80% in corporates currently.

US monetary policy

This partly reflects a cautious stance on macro level US interest rate risk: “The recent widening of US Treasuries has had more impact on the belly and long end, while we are positioned with shorter duration,” says Arevalo. He is avoiding investment grade emerging market paper that is closely correlated to US Treasuries. This includes many sovereigns and corporates in Asia and the Middle East. “Overall, our strategies are exposed to 45 of the 80 sovereign issuers in emerging markets, via their hard currency debt”.

The short duration fund has an effective duration of around three years, while the other funds that have a weighted average duration pretty close to their benchmark duration (though they have less in the longer maturity buckets). They stay within two years of benchmark duration so that rate risk does not overwhelm the idiosyncratic risks that Jupiter is getting paid for.

It seems likely that Federal Reserve tapering will begin in late 2021 and rate rises in 2022. That said, Arevalo does not expect a repeat of the 2013 taper tantrum for two main reasons: “Policy intentions have been clearly telegraphed and so should not surprise anyone. And emerging market economies are now much more resilient with stronger capital accounts. We do however expect that tighter US monetary policy could strengthen the USD. Hence there is virtually no local currency exposure because the yield pickup is not enough to compensate for the currency risk, and this is true even after at least 20 emerging market central banks have raised local interest rates. Faster inflation may lead to further rate rises, which may not yet be fully priced in”.

Corporate High Yield

Currently, Arevalo is focused on clipping coupons and differentiation. “All of the funds now yield more than 4% net in USD, and this is a function of the opportunity set. There is no yield target”.

Corporates offer the best risk adjusted returns now, and that has also been true historically. “They offer higher spread, lower interest rate risk, and we can even find names that benefit from a stronger dollar. Some sovereigns have a mismatch on their external debt but multinational or exporter corporates with USD revenues and local costs, and currency aligned assets and liabilities, could benefit”. The Jupiter Emerging Market Debt strategies own around 110 out of 821 hard currency corporate issuers in emerging markets and has recently invested in some airlines for the first time. The manager is taking an active approach but is not making aggressive bets: an overweight position in a corporate would be around 1% above the benchmark.

Yet he has been structurally underweight of Asian corporates, which are dominated by China and real estate, even before Evergrande contributed to spread widening, partly caused by leveraged private bank investors facing margin calls and outflows from funds. Arevalo has had no exposure to Evergrande, and fears that China will prioritise local retail bonds over external Eurobonds. 

The Jupiter Corporate Bond strategy has had no exposure to any corporate defaults since the fund was launched in 2017. “We do fundamental analysis and assess corporate governance and transparency”. Headline default rates on global EM corporate debt could be above 2%, but this is mainly explained by Asia and in turn by Evergrande. “An Evergrande default could push the Asian default figure up to 5.5%”. In any case, recovery rates on EM corporate debt, can be around 30-40% and on average have been higher than on US high yield (though this can vary a lot with domicile and bond structure).

Latin America and Africa

The biggest geographic overweight is Latin America, including Mexico, which he views as one of the more politically stable countries in the region. Arevalo has also been selectively investing in a small number of African sovereigns, including emerging markets such as Morocco, and frontier markets such as Nigeria and Zambia. He is conscious of liquidity risk in these markets but mitigates this partly through relatively high cash weightings of around 6%. This dry powder also enables opportunistic excursions into special situations, such as Zambia, which traded down to 64 cents on the dollar after becoming the first country to default during Covid. Arevalo had a constructive outlook on the election there but has nonetheless taken profits at around 77 due to concerns about hidden exposure to Chinese creditors being higher than what was reported, which could complicate restructuring.

ESG Update

Jupiter Emerging Markets Corporate Bond and Jupiter Global Emerging Markets Short Duration Bond, are scheduled to become article 8 funds under SFDR, while Jupiter Emerging Sovereign debt and recently launched Emerging Market Income funds will be article 6.

“We anticipate that article 8 requirements would result in around 20% of the investible universe of corporates and sovereigns being excluded, based on sectors such as tobacco, weapons and coal, and UN Global Compact violations. We do not exclude energy as it is a large sector in emerging markets, especially for quasi sovereigns, and we want to help companies’ energy transition through engagement,” says Arevalo.

Jupiter has always tuned into companies’ ESG conference calls and in some cases, the manager sees scope to improve corporate behaviour through engagement, which can also contribute to tighter spreads.

Green bonds already tend to have tighter spreads. Growing green bond issuance in emerging markets can provide some portfolio diversification: “while green bonds do yield less, they can also provide useful portfolio diversification benefits since they may hold up better during a market panic and flight to quality,” says Arevalo. Jupiter checks documentation in order to avoid “greenwashing”.

Travel, communication and counterparties

Site visits should soon also help to gauge issuers’ green credentials. The team has not been able to do any travel for 18 months, but has found that sovereigns and corporates offered better virtual access, including virtual roadshows. Jupiter has also continued to strengthen its relationships with local counterparties to access more pools of liquidity. Going forward into late 2021 and 2022 the team very much look forward to getting back on the road. “A zoom call cannot give us the on the ground feeling of what is happening, which we can get by talking to journalists and politicians. Our Chinese analyst will be visiting many cities in China in December,” says Arevalo.

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