Managing Volatility in EMD

Emerging market debt is a volatile asset class, but there are ways to manage this volatility through thoughtful portfolio construction, Aviva Investors’ Aaron Grehan says.

Investing in emerging markets is not without risk; it can be a highly volatile asset class. Therefore, even the debt component should not be seen as a defensive allocation within a multi-asset portfolio, but more as an alternative to high beta credit.

But once you are comfortable with the role emerging market debt (EMD) plays within a portfolio, there are certainly ways to manage the volatility of an EMD allocation.

Two of the key methods to do this require understanding the fundamental outlook of the individual investments, utilising both top down and bottom up factors, and paying attention to the timing of your entry into particular assets, Aaron Grehan, Deputy Head of Emerging Market Debt and Hard Currency Portfolio Manager at Aviva Investors, says.

Understanding the fundamentals of EMD is largely about understanding the particular characteristics of the country you invest in. What is the trajectory of the economy? How does it respond to different market conditions? Are there signs of improvement on a policy level?

The Middle-Eastern country of Oman is a good example, Grehan says. Being largely dependent on oil exports, Oman was severely impacted by negative market conditions last year and the outlook appeared extremely challenged. In addition, Oman suffered from poor fiscal management for years with little sight on improvement.

But in the last few months things are appearing to change .

“Oman, for the past two or three years, has shown no indication of changing policy. Fiscal management has been very poor and the destruction in metrics has been very significant,” Grehan says in an interview with [i3] Insights.

“It very quickly moved from an investment grade credit to a single B, one of the quickest moves between those ranges that I’ve ever seen,” he says.

Oman moved from a BBB rating to a single B rating in little over three years, according to Standard & Poors.

“So it is a credit that you were required to have a pretty negative view on,” Grehan says.

“But now under the rule of the new Sultan, there is a reform program underway that is looking to address some of those imbalances that have been in Oman for a very long time.

“That alongside an improving oil outlook and an oil price that is currently above the budgeted price, is leading us to be more constructive on Oman. We now see the potential for improvement and understand the impact that improvement can have.

“Now, it is a very long road for Oman to turn its metrics around and move back to being seen as a more stable BB country, but the initial signs are positive. It typifies the investments we are looking for in the current environment, not only countries that benefit from a global growth recovery, but also those that are strengthening policy to improve their domestic economies,” he says.

The changed outlook for Oman caused Grehan and his team to increase their exposure earlier this year.

“Positive rhetoric and growing talk of reform got our attention and we put Oman on our focus list,” Grehan says.

Then in January 2021, the country issued new bonds, which created an opportunity for Aviva Investors to increase their holdings.

“The new issue process and opportunity to re-assess revised data allowed us to do proper due diligence on the country and led us to turn our view more constructive. We have now covered the underweight positions and we continue to assess it, as we believe it has the potential to justify an overweight position in the coming months,” Grehan says.

“In general, to move from a negative view to one that is more constructive or even positive will take time. We monitor countries very closely and make sure we are considering all of the relevant factors so that we can be confident with our investment decisions.

“We want to see that real changes are being made and that there is a long-term commitment to these changes,” he says.

Volatility and Entry Points

Timing your entry into an asset is another important tool to manage volatility, Grehan says.

“Timing your entry is key. You may have exactly the right approach and end conclusion when it comes to the view on a country, but the point at which you make that investment can actually have a big impact on the returns you generate,” he says.

“Within the investment process our valuation analysis determines a view on the compensation for the risk we are taking. We do not just identify improving fundamental trends, we need to make investments that deliver attractive returns for our clients. Volatility is inherent in financial assets and ideally we are looking for investments where we believe the risk reward is skewed in our favour.

“If you enter into a position when valuations are stretched and risk reward is unattractive then clearly your ability to deal with volatility is much lower as losses would be incurred more quickly. Managing volatility has as much to do with when you enter a position as it does how you react when once it is in the portfolios ,” he says.

It is not all theory either. Last year, the team was placed in a difficult situation, when some of their long positions in Ivory Coast and Kenyan bonds registered severe losses. But they stood firm, as they believed the fundamentals of these bonds justified the allocations.

“Last year, we were sitting on significant losses on some of our long positions and it was extremely uncomfortable. But we believed in the strength of our investment rationales and felt confident that asset prices would recover, so we were able to actually add to those long positions,” he says. It turned out to be a good decision, as the bonds did indeed recover.

High Yield

It is no coincidence that Grehan found opportunities in the Ivory Coast and Kenya last year, as the high yield sector in general has been a good place to be in the current market conditions, where growth and careful optimism about an economic recovery dominate.

Grehan suspects that these conditions will continue for some time.

“High yield is where we see the potential for greater returns,” he says. “If you look at the spreads for investment grade – so looking at the JP Morgan Emerging Markets Bond Global Index, which is the sovereign index – and you look at the investment grade component of that index, then you are very close to historical tight spreads,” he says.

“At the moment, the index spread is at about a 160 basis points spread over treasuries for the investment grade component, which is very close to historical tights.

“So in short, investment grade spreads are close to their historical tights and their ability to compress from here is limited. We don’t feel that they offer particularly attractive carry potential, and limited compression potential. We also have concerns about higher US rates and how these impact returns.

“So those things together mean that our outlook for investment grade is not particularly positive,” he says.

In comparison, high yield assets trade significantly above their historical tight spreads, while the current environment of ongoing growth recovery and increasing optimism should support the performance of high yield bonds in the near future.

“The environment we see should be supportive of high yield assets,” Grehan says. “However, our portfolio construction process looks to avoid dominating biases, and so although our preference is for high yield assets, we make sure that these are balanced with an exposure to investment grade in a way to generate the best risk adjusted returns and manage the exposure to directional or beta risk.”

This article is paid for by Aviva Investors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.