emerging-market-bric

In the high-yield space, it’s time to look beyond the U.S. and Europe, says Robert Abad, product specialist at Western Asset Management in Pasadena, Calif.

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While he’s constructive on U.S. high-yield credit, he’s also cautious. He finds default risk, particularly in the energy sector, has receded — and that the financials and technology sectors show improving fundamentals. But, he still warns, “After a strong run in 2016, current valuations are fair at best.”

In the global space, “we’re not as constructive on European high-yield credit,” he says, citing low yields and the fact that Brexit negotiations “could leave U.K. issuers vulnerable to unanticipated bouts of market volatility.”

Read: The upside of U.K. prime minister’s failed election bet

To avoid that, Abad’s looking to emerging markets, where he sees “an attractive combination of improving fundamentals and return potential.” He finds opportunities come in the form of debt that’s offered in U.S. dollars as well as in debt offered in local emerging market currency.

For instance, “We like the U.S. dollar-denominated debt of Brazilian oil company Petrobras,” says Abad, whose firm manages the Renaissance Multi-Sector Fixed Income Private Pool. “This company has weathered the sharp drop in crude oil prices over the past years, and has overcome some heavy regulatory and political headwinds.” He describes Petrobas as “a good turnaround story with further room for improvement.”

As of June 7, the yields of Petrobras’ longer-dated bonds were better than those of Brazilian sovereign debt. And, “We see Petrobras’ yields converging toward 5% over the next few months,” says Abad.

Read: Where to find income opportunities

For debt in local currency, he likes Argentinian government bonds. The country’s market-friendly administration, which took office after the November 2015 election, has helped revitalize the economy and restore capital markets access, he explains.

“Argentina now represents a welcome fixed-income destination for investors,” says Abad. And, “after factoring [in] the potential for currency weakness, we believe investors should benefit from these holdings as domestic interest rates decline on the back of easing inflation pressure.” (What’s more, on June 19, Argentina announced the surprise sale of a 100-year bond in U.S. dollars.)

However, there are both advantages and disadvantages when investing in locally denominated debt. “While the advantages outweigh the disadvantages,” says Abad, “investors still have to be selective.”

Closer look at EM debt in local currency

Abad describes three advantages of locally denominated debt.

  1. Attractive yields. “At yields exceeding 6[%] to 7% on average, the return potential of local emerging market debt is much higher,” says Abad, compared to sub-1% rates in the U.S., Europe, Canada and Japan. This is especially the case “as many central banks in those countries are poised to ease monetary policy.” Read: Waiting game for central banks–even the Fed
  2. Low correlation. Locally denominated debt has a low correlation with U.S. interest rates because of different growth and interest rate cycles. For example, U.S. growth is slowing and the Fed is normalizing interest rates, explains Abad, which puts upward pressure on bond yields. Meanwhile, emerging markets such as Russia are coming off the bottom of the economic cycle following the recent collapse in oil prices. “We expect the Russian ruble to continue its recovery,” he says, “and for [the] policy rate to continue moving lower from its [December 2014] high of 17%.”
  3. Pure picks. “Exposure to local emerging market debt is a pure investment in the sovereign story,” says Abad. “With higher-yielding U.S. dollar [exposure] on paper, you’re typically exposed to more idiosyncratic risk, such as corporate default risk and liquidity risk.”

Despite these advantages, there are risks that make investing in U.S. dollar-denominated debt more advantageous at times.

“The biggest risk with local emerging market debt is currency volatility,” says Abad. For example, in the past three years, “we have seen a tremendous amount of volatility in [emerging market] currencies,” he says, “such as the Mexican peso and Brazilian real, on concerns over the pace of Fed rate hikes, local political developments, the possibility of a sharper-than-expected China slowdown and collapsing commodity prices, such as [for] crude oil.”

Still, last year, his firm took advantage of volatility to increase its local exposure to Argentina, Russia, Mexico and Brazil, expecting global growth would remain supportive of emerging markets over the longer term.

“So far, this scenario has borne out,” he says, as of June 7, “with local emerging market debt posting solid returns in 2016 and year-to-date.”

Read:

Don’t underestimate high yield

Were they right? This PM’s ‘not loading up on bonds’

Originally published on Advisor.ca
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