Emerging market debt denominated in local currencies enjoyed a strong year last year, but the first quarter of 2024 saw hardly any movement. For investors looking for diversification, we discuss a leading fund in this category.
Last week, my colleague Ronald van Genderen covered stocks from emerging markets and their underperformance compared to developed nations over the short and long term. Indeed, this asset class has failed to live up to the high expectations set after a strong period in the early 2000s.
Investors in emerging-market bonds in local currencies might also feel disappointed, as over the last ten years, the annual return of 2.2% in euros for the JPM GBI-EM Global Diversified Index lagged behind the 2.4% for the broad Bloomberg Global Aggregate Index and far below the 5.6% of the JPM EMBI Global Diversified Index, which follows hard currency, primarily USD bonds from emerging markets.
Strong Dollar
This is primarily a currency effect driven by a strong US dollar. In the early 2000s, the dollar weakened, and both bonds in local currencies and stocks from emerging markets performed excellently. It’s hard to identify the turning point after so many years, but according to GMO, investors will look back at this period as an exceptionally attractive entry point. The overvaluation of the US dollar is at relatively extreme levels, which will likely provide a strong and sustained tailwind for non-dollar assets in general, as the fund house suggests.
On the other hand, it could be argued that given geopolitical conflicts in Gaza, Ukraine, and the strength of the American economy relative to other countries, investors will likely remain risk-averse, and in such a scenario, the US dollar provides peace of mind. Year to date, the Indonesian rupiah, among others, weakened due to a current account deficit and fears that the future populist policy of newly elected President Prabowo Subianto could further harm the budget.
Moreover, by the end of March, the effective yield on US Treasuries was very close, at 4.5%, to the 4.6% on government bonds of emerging countries in local currencies. In other words, investors are now not compensated for the typical exchange rate risk involved in investing in debt securities from emerging markets. The yield on hard-currency EMD was naturally higher at 6.6% than that of US Treasuries as of the end of March 2024, to compensate investors for the credit risk taken. However, spreads narrowed last year from roughly 500 to 350 basis points (ICE BofA indexes).
Pimco
The strategies that prominently feature on Morningstar’s radar possess, according to the qualitative judgment of the fund analysts, a strong management team and a robust investment process, or these qualifications are attributed based on an algorithm that evaluates investment funds using the same framework. In this article, we highlight a fund that meets these criteria and is followed by Morningstar analysts.
The PIMCO GIS Emerging Local Bond Fund receives a People and Process Pillar rating of Above Average and High, respectively, resulting in a Morningstar Medalist Rating of Silver. (More expensive fund classes have Morningstar Medalist Ratings of Bronze or Neutral). The fund achieved a return of 1.2% in euros over the first quarter of 2024, while the JPM GBI-EM Global Diversified benchmark only rose by 0.1%. Thus, a strong start to the year, though it is especially the long-term results of this five-star fund versus the competition that are noteworthy.
That said, the team’s focus on risk management and diversification did not always proceed without hiccups. During the Covid-19 sell-off in the first quarter of 2020, the strategy lost 23% due to, among other things, overweight positions in Brazil and Ukraine. Yet, the team managed to reposition the portfolio and benefit from the currency rally in the latter half of that year, finishing ahead of the index for that year. The cautious stance on Russian debt and the underweight in Poland also proved beneficial in 2022, and when bond markets recovered in 2023, the fund excelled thanks to a well-timed shift to bonds with longer maturities.
A Disciplined and Risk-Conscious Approach
This approach distinguishes itself from other funds in the global emerging market bond – local currency Morningstar category through careful and thoughtful portfolio construction and continuous improvements in the investment process. It utilizes PIMCO’s strong macroeconomic expertise and extensive analytical resources, while the fundamental approach is complemented by a series of quantitative strategies aimed at reducing trading costs and exploiting inefficiencies in the debt markets of emerging countries. These include, for example, models that select between bonds and derivatives or seek relative value across interest rate curves and currencies to optimize the portfolio considering index changes and market flows. Strict limits for individual country and currency positions are intended to mitigate concentration risks.
An Experienced Team in the Sector
The management team behind this fund has experienced significant turnover in recent years, but this does not outweigh its strengths. Lead manager Pramol Dhawan joined PIMCO in 2013 and took over this strategy and the leadership of the emerging-market debt team in 2019 when former manager Michael Gomez left the company. Dhawan initially shared responsibility for the day-to-day management with his colleague and PIMCO veteran Ismael Orenstein, but the latter left the firm early in 2023.
Orenstein’s replacement is Michael Davidson, who joined the team in 2017 and has been at the controls since 2020. In total, six portfolio managers from the 31-member investment team have left over the past two years, but capable replacements have always been found, and overall, the team remains more experienced and better equipped than most of its peers.
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Thomas De Fauw is a manager research analyst at Morningstar. Morningstar analyses and evaluates investment funds on the basis of quantitative and qualitative research. Morningstar, one of Investment Officer’s knowledge partners, each Friday highlights the performance of a specific fund in a specific sector in the Morningstar Fund Radar article.