Fixed Income

EMD Relative weekly notes

Week Ending June 30, 2017


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Emerging market debt in our opinion represents a large, diversified opportunity set for fixed income investors. There is investment grade dollar EM debt which tends to exhibit significant correlation to US treasuries—and is likely to perform well in periods of risk-off and can offer (in general) more yield-per-credit rating than other ‘risk’ asset classes. There is non-investment grade EM debt—which can be expected to perform well in stable-to-aggressive risk scenarios—and there is local currency EM debt—which tends to be correlated to US dollar trends, but historically has achieved strong performance in periods of a declining USD (but vice versa in a strong USD environment).

However, like all broad asset classes, investors not intimately familiar tend to talk about it in terms of convenient shorthand and the most recognizable index. In emerging markets, that is the sovereign dollar JP Morgan index. And it is that index that investors think of as having "exposure" to EMD. As such, vehicles designed to track that index have been the one passive investors have flocked towards.

Naturally, that phenomenon has led to inflows that has made that part of the EM universe fairly highly priced relative to its own history, if not so expensive relative to other QE-inflated fixed income sectors. But unlike, say, US equities, where passive indexed inflows have lifted all boats, the concentration of passive inflows into only one part of the broad EMD investable universe actually creates opportunity.

This year, the sovereign EM index has outperformed the corporate EM index in every month through May. Sovereign returns have outpaced corporates by just over 150 basis points as of this writing. The attached chart shows normalized yields for sovereigns and corporates (orange line) from the start of this year, and it demonstrates the divergence that has occurred thanks, we believe, to passive investing's sovereign concentration.

Source: Bloomberg, JP Morgan. JP Morgan EMBI Global Diversified Blended Yield (white) & JP Morgan CEMBI Broad Diversified Yield (orange); data as of June 28, 2017. Past performance is no guarantee of future results. Other periods would have achieved different results. Investors cannot invest directly in any index.

For us, this creates opportunity. For investors happy to settle for just "exposure", we think the probability is mathematically very high that going forward they will do worse than they otherwise could.

In our view, that turn may have already started. In the month of June, as of this writing, corporates have outperformed sovereigns by about 46 basis points. While it’s too soon to be certain, we expect that going forward those parts of the EMD opportunity set least affected by passive inflows have the potential to outperform as yield compression slows and carry becomes a more important component of total returns. We hope that investors settling for the easiest solution to exposure to the asset class take the time to consider whether, going forward, utilizing a single sleeve, passive EMD approach meets their investment objectives.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.