For this week’s Morningstar Top 5, we look at the best-performing funds investing in emerging market local currency bonds. These funds ended 2022 with a loss of 9.9 per cent, measured in dollars, or 4 per cent in euros. The outlook for this risky asset class does not seem favourable at first glance, although some fund managers say there are opportunities.
Risky assets globally were under great pressure last year due to high inflation, war and recession fears, and emerging market bonds were also affected. Most of the damage done was on US government bonds, but credit risk in emerging economies themselves, especially those dependent on energy imports, also rose. Furthermore, 2022 was a year of extremely low new issuance (less than half the amount issued in 2021) and large outflows. Morningstar data shows that European investors took more than €9 billion out of the global emerging markets bond - local currency Morningstar category last year through the end of November. In 2021 and 2020, the outflows were €5 billion and €7.7 billion respectively.
The outlook for this asset class largely depends on what is decided in Washington. If the Fed is to be believed, we are not yet at the end of the rate-hike cycle, so investors should not expect much improvement for emerging-market bonds at first glance. Still, emerging-market local-currency bonds seem well positioned for a so-called soft-landing (and eventual rate cuts) in the United States, while a deep recession would likely drive investors back to the dollar.
In first place, we find the Candriam Bonds Emerging Market Debt Local Currency fund managed since March 2015 by Diliana Deltcheva the head of Emerging Market Debt. She is assisted by Richard Briggs who came over from GAM Investments in 2022. In December, managers increased duration, especially in countries such as Brazil, Mexico and South Africa where spreads are attractive versus US government bonds, often because they started rate hikes earlier. However, they are more cautious regarding duration in Asia and anticipate a change in policy expectations as China reopens. About 75 per cent of the current portfolio is investment-grade and 25 per cent high-yield bonds, with an average credit rating of BBB-.
Pictet-Emerging Local Currency Debt is rated Neutral by Morningstar analysts. Mary-Therese Barton, a member of Pictet’s EMD team since 2004, took over leadership of the group (and this strategy) in May 2018 when former manager Simon Lue-Fong left the firm. The transfer in 2018 coincided with a period of weak performance and the departure of three experienced team members. They have since been replaced and staff turnover has stabilised. The team consists of eight portfolio managers and two strategists and has an average of about 19 years of investment experience.
The team meets daily to discuss its macro vision, bottom-up country selection and portfolio positioning. All eight managers contribute investment ideas for the various strategies within the group. Although this strategy follows a team-based approach, Barton broke with tradition in 2018 by appointing one of its new hires - veteran Alper Gocer - as lead manager. Grocer monitors the portfolio’s overall risk profile, but most ideas and decisions are still discussed in group discussions led by Barton. The portfolio can hold up to 30 per cent of assets in off-benchmark positions (mostly emerging-market bonds in hard currency or US government bonds) and can also use significant over- and under-weightings in emerging-market currencies of up to 40 per cent.
Further in the list some now familiar names such as Man GLG Global Emerging Markets Local Currency Rates which could benefit from its lower duration and overweight in short-term bonds this year. As of end-December 2022, duration was 3.38 versus 4.94 for the JPMorgan GBI-EM Global Diversified Composite benchmark and some 40 per cent of the portfolio was invested in bonds with a maturity of less than 1 year versus less than 5 per cent for the benchmark. NN (L) Emerging Market Debt (Local Currency) was still in first place at the end of the third quarter. The PIMCO Emerging Markets Advantage Local Bond Index UCITS ETF, which tracks the performance of an internally GDP-weighted basket of emerging market local government bonds and currencies with a maximum exposure of 15 per cent per country, also remains in the top five.
Thomas DeFauw is manager research analyst at Morningstar. Morningstar analyses and evaluates investment funds based on quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners and ranks five mutual funds or providers every week.