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The ongoing challenge of finding diversification in emerging market debt

In the second part of Citywire Selector's look at EMD dynamics, two outperforming PMs share how they find uncorrelated opportunities in the emerging world.

The ongoing challenge of finding diversification in emerging market debt

Citywire plus-rated Gerard Fitzpatrick, head of fixed income at Russell Investments, said diversification is a fundamental consideration. ‘It’s super important,’ he said. ‘Having a concentrated position is challenging as you can potentially lose all your money in one name.’

He prefers to look at a broad number of countries, currencies, and styles of management. External fund managers are appointed on the basis of their strategies and execution. These factors are all built into the portfolio construction to give the required spread of approaches and exposures.

‘Diversification has always been important but it’s more so right now,’ he said. ‘If you have just one manager and approach, or a highly concentrated position, then it’s binary in the fact that you either win or lose quite heavily.’

Fitzpatrick has what he described as a ‘stage one’ – or modest – overweight position in hard currency. ‘We do have a very minor overweight in local currency as well but our preference is more on the hard side,’ he said.

A key reason for this is his belief that the bad news is behind us. ‘We’ve had the defaults of Ecuador, Argentina and Lebanon,’ he said. ‘That’s cleared out some of the negative news and gives us a more positive outcome from here.’

Other encouraging factors include an accommodative US Federal Reserve keeping interest rates low and commodities recovering from the sell-off earlier this year. His overall view, therefore, is that the prospects are moderately positive, although he acknowledges it’s a challenging asset class.

‘We always look at the world in terms of outlook and try to form best- and worst-case scenarios,’ he said. ‘Our central case is a slow recovery as we don’t think we’re out of the woods with Covid. There’s uncertainty out there and that’s understandable with what we’re dealing with now.’

Adjusting to swings

Citywire plus-rated Joanne Baxter, a manager in the emerging markets team within JP Morgan’s global fixed income, currency & commodities group, said the back end of 2019 and early weeks of this year were a good period for risk assets – in both emerging and developed markets.

‘Within emerging markets, high yield rated corporate bonds performed best, followed closely by local currency debt, which benefited from a weaker dollar and rallying rates in most local markets,’ she said.

However, the backdrop changed almost overnight. ‘The picture since February is distinctly different as a result of Covid-19 and the oil price shock, as investors rotated into assets with lower credit or beneficiaries of central bank support,’ she added.

This has resulted in mixed performances for emerging market assets. ‘High grade sovereign and corporate bonds have performed best, whereas high yield bonds have been struggling as default risks have increased,’ she said. ‘Local currency rates also performed strongly on the back of aggressive monetary easing in most emerging markets.’

Emerging market FX, meanwhile, suffered from a flight to developed market currencies. However, Baxter points out that emerging market debt, as a whole, has returned more than 3% since August 2019. ‘It underpins the view that the asset class has matured into a viable alternative for conservative investors, even in periods of extreme volatility,’ she said.

This article originally appeared in a supplement published alongside the October edition of Citywire Selector magazine.

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