FIXED INCOME Emerging Markets Sovereign Debt: Does Active ... · Emerging Markets Sovereign Debt:...
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OC TOBER 2019 1
Emerging Markets Sovereign Debt: Does Active
Management Pay?
The performance of Emerging Markets Sovereign Debt can—and does—vary widely from
country to country. In this piece, Barings’ Cem Karacadag explores how an active approach
can be key to selecting the most attractive opportunities, while also avoiding the bad apples.
While general market conditions for emerging markets debt (EMD)—conventionally known as market beta—may be the main
driver of EMD returns over short time horizons (days or weeks), idiosyncratic country fundamentals and risks ultimately
drive prices and performance over the long term. As a result, there is sizable dispersion in the total returns on the debt of
70+ emerging market sovereigns in the J.P. Morgan EMBI Global Diversified (EMBIGD) bond index.
BARINGS INSIGHTS
FIXED INCOME
BARINGS INSIG HT S OC TOBER 2019 2
In the first three quarters of 2019, for instance, the EMBIGD returned 12.9%.1 While the great majority of EM sovereigns
generated positive returns, some countries’ debt returned significantly more than others’. Eleven sovereigns outperformed
the index by more than five percentage points in total return, and 10 sovereigns underperformed the index by more than
five percentage points in total return (FIGURE 1). On an absolute basis, while “only” four countries generated negative returns
during this period, three of them fell sharply. Lebanon returned -10%, Argentina returned -37%, and Venezuela returned -57%.
Performance data for three years through September 30, 2019 paints a similar picture. In the past three years, the EMBIGD
returned 14.4%.1 Once again, the vast majority of sovereign debt delivered positive returns, but some countries much more
so than others. Seventeen sovereigns outperformed the index by more than 10 percentage points in total return (FIGURE 2).
And once again, on an absolute basis, Lebanon (-11%), Argentina (-46%), and Venezuela (-78%) fell precipitously.
1. Source: J.P. Morgan. As of September 30, 2019.
FIGURE 1: Country Excess Returns Relative to EM Sovereign Index (Year-to-Date)
FIGURE 2: Country Excess Returns Relative to EM Sovereign Index (3-Year)
SOURCE: J.P. Morgan. As of September 30, 2019.
SOURCE: J.P. Morgan. As of September 30, 2019.
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BARINGS INSIG HT S OC TOBER 2019 3
The moral of the story is simple yet powerful: country selection matters and matters a lot. Selecting
the right countries requires active management and an investment process that seeks to pick the right
apples, and avoid the bad apples in the basket. Similarly, a specific country’s sovereign debt should
never be bought just because it is in the index, or without a full understanding of the risks and whether
or not potential returns compensate for the risks. A remarkable—and unusual—feature of EM sovereign
debt performance over the past few years is that investment grade-rated sovereigns have delivered
higher returns than high yield-rated sovereigns. This is partly because of the longer-duration bonds
of the former, but it also highlights the importance of discriminating among countries, especially high
yield sovereigns.
A few selective comments on some of the best and worst performing countries:
Argentina has been one of the most difficult emerging market sovereigns to analyze and forecast in
recent years: President Mauricio Macri won a historic election in 2015, effectively ending Kirchnerism,
and embarked on a macroeconomic stabilization program with heavy reliance on market financing
and subsequently an IMF program. In the end, the pain of adjustment led to Argentina’s traditionally
populist electorate delivering an unexpected and heavy defeat to President Macri in the primary
elections this past August. Barings’ EMD sovereign strategies were moderately overweight going into
the primary elections, but have since moved Argentina to underweight.
Lebanon’s financial challenges, including a high fiscal deficit and high debt burden, have been
well-known for a long time, but the country’s repayment capacity has been supported by non-
resident (Lebanese) deposit inflows. The sustainability of these inflows, in our view, has always been
unforecastable and potentially reversible in response to challenging domestic and regional politics.
Barings’ EMD sovereign strategies have not had any exposure to Lebanon in recent years.
Venezuela’s financial challenges have also been well known for many years, yet its future has been
difficult to forecast and analyze without visibility on the potential timing and nature of a regime
change. Venezuela’s very sizable contribution to index returns for many years made it tempting to
invest in, especially before its sovereign default in early 2018. Over the years, Barings’ EMD sovereign
strategies have had very minimal exposure to Venezuela and have had zero exposure for the period 1.5
years before its default until the present time.
Several sub-investment grade EM countries generated meaningfully higher returns than the index in
2019 and in the past three years, but each one of them is a unique and complicated story that, in our
view, required in-depth analysis and high conviction to invest and stay invested in, even during periods
of volatility. Barings EMD sovereign strategies have had exposure to Ghana, Angola, Ecuador, Ukraine,
El Salvador, Armenia and Brazil, among the top performers, over the past three years.
In addition to choosing not to invest in several countries in the index, the Barings team has invested,
and exploited value, in several countries that are not in the index, among them Albania and Macedonia.
This points to the potential benefits of broadening the opportunity set beyond the index and selecting
the right opportunities rather than just those that happen to be in the index.
“A specific country’s sovereign debt should never be bought just because it is in the index, or without a full understanding of the risks and whether or not potential returns compensate for the risks”
BARINGS INSIG HT S OC TOBER 2019 4
Where do we go from here? Are there generalizations we can and should make about EM sovereign debt? Yes and no.
While EM Sovereign BBB spreads are near their tightest levels versus U.S. Treasuries in the last 10 years (FIGURE 3), we see
good value in several EM investment grade sovereigns, including Mexico, Colombia, Indonesia, Romania and Russia.
Conversely, the spread between high yield sovereigns and investment grade sovereigns—as measured by the difference
between the EMBIGD 75th percentile spread and EMBIGD 25th percentile spread—is approaching the widest level of its
decade-long range (FIGURE 4). Does that mean we should pile into high yield sovereigns?
Our answer is decidedly “no.” While our proprietary investment process and sovereign default probabilities indicate that
the spreads on most EM sovereigns (over)compensate for actual default risk, the margin of uncertainty for cumulative
probabilities of default over time varies from country to country, as does our conviction in the credit trend.
Hence, while we can comfortably speak to the potential benefits and high merits of investing in EMD, picking the right
countries and securities is everything, in our view.
FIGURE 3: EM Sovereign Spreads Near 10-Year Tights FIGURE 4: HY-IG Sovereign Spread Differential Near 10-Year Wide
400 bps
Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-18Jan-17 Jan-19
350 bps
300 bps
250 bps
200 bps
150 bps
100 bps
EMBIGD BBB spread (bp)
400 bps
Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-18Jan-17 Jan-19
350 bps
300 bps
250 bps
200 bps
150 bps
100 bps
EMBIGD 75th percentile spread to 25th percentile spread di�erence (bp)
SOURCE: J.P. Morgan. As of September 30, 2019. SOURCE: J.P. Morgan. As of September 30, 2019.
Cem KaracadagManaging Director
Cem Karacadag is Head of Barings’ Emerging Markets Sovereign Debt Group. Cem is the lead portfolio
manager for the Emerging Markets Sovereign Debt strategy and backup portfolio manager for the
firm’s Emerging Markets Local Debt strategy and Blended Total Return strategy. Cem has worked in the
industry since 1994 and his experience has encompassed sovereign credit analysis, macroeconomic
policy research and advice, and emerging markets fixed income strategy. Prior to joining the firm in
2014, Cem was at OppenheimerFunds, where he worked on sovereign hard currency and local currency
investments in Eastern Europe and Asia. Before Oppenheimer, he worked at Credit Suisse covering
emerging market sovereigns in Asia and Latin America, and at the International Monetary Fund, where
he focused on monetary policy instruments, exchange rate policy and bank restructuring in China,
Indonesia and Eastern Europe. He also held positions at Standard & Poor’s and the Federal Reserve
Bank of New York. Cem holds a B.A. in Economics from Tufts University and an M.A. in International
Economics and European Studies from Johns Hopkins University.
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