“The world needs to be prepared for a debt crisis in emerging markets. Rising interest rates will draw capital away from vulnerable countries”, warned Kristalina Georgieva, director of the IMF. For the time being, not everyone feels moved by this warning, “emerging market debt is a paradise for active investors”, according to Wouter van Overfelt, senior portfolio manager EM debt at Vontobel, in an interview with Fondsnieuws, Investment Officer Luxembourg’s Dutch sister publication.
Vontobel’s Emerging Markets Corporate Bond strategy (ISIN: LU1750111616), with a year-to-date return of 12.3 percent in euros, was number one in the Morningstar Top 5 for best performing funds in the EM Corporate Bonds category.
“Something is always happening somewhere in the world and there is definitely a lot of headline risk in emerging markets, but that is exactly why active managers in that corner get a lot of opportunities,” said van Overfelt, whose fund typically has a turnover of 200 to 300 percent a year.
Van Overfelt said he recognises some major themes in his playing field, such as the crisis in the housing market in China and the fear that spillover effects will occur there. “We are not worried about that. That market is volatile, but that is exactly what we are looking for as active investors. We also follow the discussion on inflation and the related commodity prices and interest rates.”
Interest rates not decisive
“The dollar interest rate is indeed very important for emerging markets and a big risk for the global market,” van Overfelt acknowledged. “Nevertheless, corporate bonds in emerging markets are much less sensitive to interest rates than other fixed income markets.” The portfolio manager says he concentrates on selecting companies that are temporarily in trouble with the expectation that recovery is possible. “For that reason, our strategy is already less interest-sensitive. An interest rate of 1 or 5 percent makes no difference, what matters is the recovery of the business”, said van Overfelt.
“The higher the credit risk, the lower the interest rate risk. There is a typical negative correlation there. Chinese property companies are now trading at an average yield of 20 per cent. For those companies, it doesn’t matter what the interest rates do. The real interest rate sensitivity of that company is close to zero.”
Van Overfelt argued that today’s benchmark level valuation of the JPMorgan CEMBI Broad Diversified index, shows that investors are getting the same compensation for EM corporate bonds - which have an average credit rating of BBB - as they are for US High Yield with the same duration. “EM corporates are therefore very attractive. EM corporate bonds are in dollars. So there is no currency risk.”
Outflow risk
Van Overfelt continued: “That does not detract from the fact that when dollar rates rise, you can usually see an outflow from EM to the US. The risk of outflow is simply very high”. According to Van Overfelt, outflows occur first in government bond markets when investors get worried about emerging markets. “In that case we also see outflows in EM corporate debt. We know the risk.”
“The credit quality of emerging markets is lower and the interest rate risk is higher. If government bonds start to underperform, it will be mainly due to crossover investors leaving. This then creates more relative opportunities in the market for, for example, quasi-government bonds, companies that are partly or wholly owned by a state.”
As an example of such a company, Van Overfelt talked about the quasi-state company PEMEX. That is a Mexican oil company with bonds in euros and dollars. “The remuneration for the credit risk should in principle be the same. But, because euro bonds are not in the benchmark and dollar bonds are, the dollar bonds will correct more strongly through, for example, the influence of ETFs if there is a lot of outflow from the market. At such times, we buy dollar bonds and sell euro bonds. If there is a lot of inflow, we act in the opposite direction.”
Credit rating does not say everything
Van Overfelt stated that the rating of companies is very strongly correlated with the country where they are located.” If a country has a single B rating, companies rarely if ever get a higher rating there. So our strategy is to look for strong companies in low-rated countries.”
The average credit rating of Vontobel’s Emerging Markets Corporate Bond portfolio is B+. According to Van Overfelt, the perception that this is super risky is not entirely justified. “A credit rating agency answers a completely different question than we do as portfolio managers. They only indicate how great the chance is that a company must restructure. They don’t reflect what happens in the event that restructuring takes place,” he said.
Credit rating agencies look at the probability of bankruptcy, not the loss in the event of restructuring. “The big difference between emerging and developed markets is precisely there. Bankruptcy doesn’t mean you lose everything. There will be a maturity extension and a smaller coupon. That makes the recovery rate super important. The essence of our fund is that we buy bonds after the risk has been realised.”
“Too many investors still focus on coupon carry in EM corp bonds. We look at the upside potential of the price. We buy bonds because they are cheap today and we want to sell them for more. That is not really a fixed-income strategy,” concluded Overfelt.
Vontobel Fund - Emerging Markets Corporate Bond N USD (LU1750111616)
