Rethinking Risk in Emerging Market Debt

Text transcript

Richard Lawrence, I’m a senior vice-president on the global fixed income team at Brandywine Global Investment Management.

So with negative yielding debt in several countries, the question is where are we looking for opportunities and what can risk-averse investors do in this environment? We’re a team that manages global bonds with a big focus on valuation. So obviously the large amount of negative-yielding debt around the world has caught our attention because we tend to favour markets where real yields look attractive. And as of the end of August, you had about $17 trillion worth of negative-yielding debt around the world.

In fact, one of the things we like to do in our work is develop a ranking of our markets by real yields from cheapest market to richest market. And an observation I had as I looked at this page from the end of August was that, for the first time ever, we actually had more markets yielding negatively on a real yield basis than yielding positively.

But the good news is as a global investor, we’ve got a fairly broad universe and a lens through which we can analyze opportunities both in developed in emerging markets. So we still find there’s an interesting opportunity to be invested in emerging markets. Now, real yields in emerging markets are currently anywhere from call it 2% to 4%; nominal yields in those markets are anywhere from 2% to almost 8%.

So while all of the headlines has focused on Europe and Japan and the treasury yields coming down a lot, yields around the world, while they performed well this year, there are still some interesting opportunities in emerging markets. Why we think those opportunities are particularly attractive is that we think that overall macro risk is diminishing. The reason I say that is we have an expectation that the U.S. and China will sign some form of a skinny trade deal, but it should be enough to sort of improve investor sentiment and that should be good for China and ergo good for emerging markets.

When we look around the world from a fundamentals perspective, we would say that emerging markets right now actually look a little bit more interesting than developed markets. If you look at leading indicators of economic activity, so LEIs and PMIs, purchasing manufacturing indices, the developed markets continue to trend downwards while some of the emerging markets look like they have bottomed out and are actually starting to mean-revert higher. So that’s where we’re finding the most interesting opportunities.

Now some investors might say, well, it’s emerging markets and therefore it’s risky. I’d like to actually turn that observation on its head and say that 10-year bunds, which at one point in August yielded minus 75 basis points and in the middle of October, they’ve actually moved a little bit richer up to minus 40 basis points — ha ha. We would argue that a market like that is incredibly risky because it’s actually not going to take a lot of good news to see bund yields move significantly higher. And the same could be said of yields in the rest of core Europe and Japan and, frankly, Treasuries, too. So the idea that you can go to these markets, as safe havens, I think these distortions in global rates are actually rendering that traditional view of fixed income a little bit untrue.

So any particular emerging markets we find attractive? Yes, absolutely. So we are not taking a scattershot approach to the emerging markets right now. There are certain markets that we would say the macro fundamentals to us look more attractive. Some of those markets that we like right now would include Indonesia, they’d include Brazil, Mexico. We like bonds in Colombia. We like bonds in Malaysia. We still have exposure to South Africa; we’re a little less excited about South Africa.

Let me put some numbers on these. So here we are in the middle of October and you’ve got 10-year bonds in Mexico yielding almost 7%. You’ve got 10-year bonds in Brazil yielding six in three quarters. You’ve got 10-year bonds in Indonesia yielding in excess of 7%, so you can prudently build small positions in these very attractive markets where real yields look quite attractive to us. The economic fundamentals look intact. Policy risk at the margin we would say is diminishing, not moving higher, and those are examples of markets that we like.