Rev up: engineering an emerging market debt portfolio

By Uday Patnaik, Head of Emerging Market Debt – Legal & General Investment Management

With a myriad of different dynamics to the rest of the fixed income world, the task of constructing an emerging market debt (EMD) portfolio can feel like an overwhelming one. Let’s examine the nuts and bolts of putting a portfolio together and take a peek under the bonnet of our latest thinking.

Slickback greenback

A key consideration when looking at EMD is how to take currency exposure. Local currency-denominated debt may help diversify portfolio risk. That said, our team currently prefers US dollar-denominated assets. We believe that US dollar liquidity conditions will continue to tighten, and as a result, the greenback will remain ahead of EM currencies over the medium term (the dollar has been in the fast lane for seven months). Tightening US dollar credit conditions have been in evidence since January. In a sell-off, we think that local paper will be less resilient, as some emerging market central banks are already facing pressure to respond to foreign currency weakness.

Trade skirmishes emanating from US policy may put global growth and trade on the skids, and potentially destabilise local currencies further, as President Trump threatens to increase tariffs from 10% to 25% on $200 billion of Chinese imports.

Firing on all cylinders

When it comes to emerging markets, the separation between macroeconomic and bottom-up investing is not as clear as you might think. Data transparency, monetary and fiscal policy, politics and regulation vary greatly between EM countries. As a result, we believe it is unwise to make a bottom-up investment decision without first considering the security’s environment. Our team start by analysing regional themes from the top down and support this with case-by-case debt issue selection.

At the moment, we are overweight in Latin America versus the index, due to a range of idiosyncratic opportunities. In Argentina, as the IMF programme gathers speed and there is less need for external funding, we think short-dated sovereign and provincial bonds will go the distance and currently offer attractive yields. We see some mileage in Petrobras, which is cleaning up its act by de-leveraging, although we hold fewer Brazilian bonds than the index overall. We scrapped our Mexico underweight about two months ago, and now hold Pemex and select Mexican financial companies.

Elsewhere, we think investors in Asia may be in for a bumpy ride, particularly those in Chinese and Hong Kong corporate bonds, given concerns over US tariffs and issuance. In the Middle East, we have changed lanes; modestly reducing our underweight with the likely inclusion of certain Gulf states into the JP Morgan EM Bond Index. However, longer-term, we see signs of turbo lag for Middle Eastern sovereigns with US dollar pegs and issuance needs (due to significant budget deficits in certain countries).

Specialist components

Emerging market investing relies on ‘best ideas’ – selectively following companies and stories. Recent market performance has underscored the value of this approach. While 2017 was the year of rising indices across the board, markets have headed into reverse gear in 2018, presenting opportunities for adding alpha through idiosyncratic names.

As mentioned above, we have accessed this theme via attractively priced short-dated Argentine provincial and sovereign debt, and also like other reforming countries such as the Ukraine. Slicked by elevated crude oil prices, we believe Nigerian banks offer strong return potential, alongside Angolan and Ghanaian debt.

We’re at the finish line. In order to arrive at your destination with a serviceable emerging market debt portfolio, it’s important to look at currency exposure, regional allocation and best ideas.