With interest rates and the value of U.S. dollar on the rise, emerging market debt finds itself in a precarious position.
According to GMO’s Victoria Courmes and Tina Vandersteel, who work on the firm’s emerging country debt team, the traditional single-benchmark approach for emerging market debt investing is “far from optimal” in the current macroeconomic environment. One reason is that investors are usually already exposed to currency risks in their bond portfolios and stocks of developing countries. Benchmarks such as the JPM EM Bond Index might have embedded market risks “that may not necessarily be desirable,” according to the strategists.
The single-benchmark approach might also constrain managers who want to seek “off benchmark” returns. In the latest GMO post, Courmes and Vandersteel wrote that “potential alpha opportunities may be de-emphasized, or even ignored completely” if investors stick to allocation decisions implied by a single index.
According to Courmes and Vandersteel, an obvious antidote to the dilemma created by the single-benchmark approach is to “remove the beta associated with emerging debt benchmarks completely, and freely use the full combination of alpha sources to target a total return over cash.” That goal can be achieved by targeting total return and using more than one benchmark.
The GMO strategists argue the total return solution will eliminate U.S. dollar duration and add long or short positions to help investors overweight or underweight benchmarks. The blended benchmark solution will add alpha “relative to a benchmark with known asset allocation properties,” such as duration and quality. In theory, the blended benchmark solution expands alpha opportunities by capturing only the desirable amount of beta exposure.
Courmes and Vandersteel said it is possible to achieve a target return of 7 to 9 percent with a mix of alpha strategies using credit, emerging market currency, and rate instruments. Around 4 to 6 percent of excess returns can be expected from investments in sovereign and quasi-sovereign credit, including performing loans and defaulted issues. Another 2 percent of excess return can be generated by duration positioning in high-quality and high-yield markets. Lastly, smart emerging markets currency positions can produce an additional excess return of 1 percent, according to the strategists.
“With U.S. interest rates rising and the USD continuing to pose challenges to holding long-only [emerging markets currency] exposure, now could be the appropriate time to consider a new approach to emerging debt investment,” according to Courmes and Vandersteel.