Best in Class: EM debt fund packs a punch

Best in Class: EM debt fund packs a punch

After three tough years, the IA Emerging Market Bond sector has had an impressive start to 2016 and, as of mid-May, was the best performing of all Investment Association (IA) groups, up 9.4 per cent year to date.

While most eyes are focused on emerging market equities, and investors are wondering if they’ve finally reached a turning point, perhaps we should also be considering whether now is a good time to either add to, or start an allocation to developing world bonds.

The four headwinds for the asset class – a slowing China, rising US interest rates, a strong US dollar and low oil prices – have all stabilised to a degree. The risks haven’t gone away, but the technicals are more supportive.

The key driver for this asset class of late has been the US dollar, and while it was appreciating, emerging market stockmarkets, currencies and debt were being punished. But recently the dollar has come back slightly and has started to stabilise. Cue a surge in risk assets and the current near double-digit returns.

The general outlook for emerging market debt is now fairly positive and there are plenty of opportunities. Argentina has just come back to the market for the first time in 14 years and even the ongoing political issues in Brazil are not dampening spirits.

With more than $9trn (£6.1trn) of global government debt trading at negative yields, the 5 per cent plus yields in emerging market bonds look very attractive. Indeed, the spreads over Treasuries are as wide as they have been for some time.

James Barrineau, co-head of emerging market debt at Schroders, said recently that non-investment-grade sovereign spreads were cheaper than they had been for 85 per cent of the past five years.

It’s almost three years since the IA decided the asset class warranted its own sector, and there are now 41 funds to choose from.

Of these, one of my favourites is Standard Life Investments’ Emerging Market Debt fund. It’s a macroeconomic-driven vehicle that aims to generate manager-attributed returns through high-conviction country selection. The fund has no benchmark constraints and will often avoid whole countries.

Although it’s relatively new, having been launched in late 2012, manager Richard House ran a similar mandate successfully for more than four years at Threadneedle, predominantly investing in external sovereign debt denominated in US dollars. He has an excellent track record of generating alpha on both funds.

Mr House’s team starts with a global evaluation of the macroeconomic environment and uses economic models to estimate the external financing needs of emerging market sovereign debt issuers. It then conducts stress tests under different scenarios.

Sophisticated risk modelling is integral to the portfolio construction process and daily risk analytics, while dedicated independent risk managers regularly assess the fund.

Mr House makes regular trips to emerging market countries and meets with local policymakers to ascertain the potential political risks.

He attends annual International Monetary Fund meetings and makes good use of his local contacts, some of which are in high places. This gives him valuable insights that many of his competitors don’t have.