Risk in focus: seeking absolute returns with emerging market bonds

You have been with Legal & General Investment Management (LGIM) for over seven years. You are also responsible for the UI I – LGIM EM Absolute Return Bond Fund (ISIN LU2243831778).

What distinguishes your team and your fund strategy within the industry?

John S. Gray: We are a team of five portfolio managers, with four based in London and one in Hong Kong. The portfolio management team is supported by our Head of EM Credit Strategy, two dedicated EM economists and also leverages the expertise of our wider LGIM team including developed market economists, strategists, 25 investment grade credit analysts and eight high yield credit analysts.

Our portfolio management team has a long track record in emerging market bonds, including in trading long/short strategies. This is an important part of our mindset and stands us in good stead in volatile phases in particular. Many portfolio managers are extremely adept at buying emerging market securities and assessing their risks but are less successful at selling these positions consistently.

What differentiates us is our focus on absolute returns and our distinct stop-loss mentality, always keeping an eye on managing the risks. Considering both, the long and the short side, is very important for the strategy and our way of thinking. Ultimately, we are targeting stable, consistent returns over a medium-term investment horizon regardless of underlying market volatility while protecting downside risk to our clients’ capital.

When it comes to looking at emerging markets globally, what is your view on the current investment environment?

The entire fixed income sector has had a difficult start to 2022 with interest rates moving the way they have. Russia’s invasion of Ukraine has been a challenge for the asset class with Russian bonds being completely removed from the major emerging market indices. This follows the Chinese real estate crisis last year. However, these periods of volatility and dislocations within the asset class create exciting opportunities for an active fund manager. We have identified a diverse set of best ideas across sovereigns, corporates and financials which offer great potential in the current environment.

What are the reasons for having low levels of exposure to China, when China is a major emerging market bond issuer?

Some context is important. China’s economy is having difficulties at present. Its zero-COVID strategy is taking its toll, whilst the country is still suffering the effects of the ongoing real estate crisis. Overall, there are several headwinds buffeting the Chinese economy from different directions. In this environment, you need to be very careful with credit selection. I think there was a good lesson to learn from the Evergrande situation and how the effects of this event spilled into the wider Chinese high yield market. Managing and understanding this type of volatility is important.

You mentioned your absolute return approach. What are the key points in bond selection and portfolio construction for your strategy?

The emerging markets provide a large investment universe with a plethora of opportunities and risks. These need to be considered when selecting bonds for the portfolio. We like to build a strong top-down macro view of the markets, before taking a bottom-up approach to credit selection. It is important to consider topics such as the movement of the US dollar or the rise in US interest rates. You cannot perform company analysis without having an eye on the macroeconomic environment affecting the emerging markets they sit within. Once we have built a strong view on the macroeconomic situation affecting a certain country, we will select the best investments to express our view. Overall, we can invest in sovereigns, corporates and financials, in both local or hard currency across investment grade and high yield bond markets.

Is flexibility in bond selection important for your success?

Absolutely! One of the reasons why I love my job is the flexibility to analyse and identify value across the entire bond universe. This means we can find the best ideas within the asset class, build in diversification into the portfolio and react quickly to the changing market environment. You can see this right now in the fund’s duration. It is currently less than 2.5 years, which has been beneficial in a rising rates environment.

When investors think of emerging market bonds, many immediately think of high volatility, the high risk of defaults and huge potential losses. How does your absolute return approach avoid or minimise these risks?

Managing volatility is important for us. The team is highly experienced and performs very detailed credit analysis before taking a position. Understanding the volatility profile of a potential investment is a key consideration. We can also minimise volatility by selectively using derivatives and EM FX where possible. This strong focus on risk management is evident with our portfolio significantly outperforming the traditional emerging market fixed income indices since the fund’s inception in May 2021.

Is an aggressive rise in interest rates imminent, given the high levels of inflation currently being experienced in the US?

This is a fascinating market environment right now in terms of interest rates and inflation. We think that much of the required Fed action is already priced in and you can see that the ten-year is struggling to decidedly break three percent on the upside. Of course, from a wider macro perspective there is a concern that an overaggressive Fed causes a hard landing in an attempt to rein in inflation, but this remains to be seen. Nevertheless, our portfolio is currently quite defensively positioned given the current environment with a focus on short-dated bonds.

India currently represents your largest country-level allocation. Why?

Our allocation to India demonstrates our investment process nicely where our top-down macro view meets our strong bottom-up stock selection. India has witnessed a solid recovery from the COVID-19 shock and growth remains robust at around nine percent. This recovery has been recognised by the rating agencies with the country’s ratings affirmed at investment grade and all outlooks now on stable. With a positive macro view on the country, we then look at the opportunity set within the country and select the best bonds to express our view. We currently like the renewable energy sector in India, where there is support from a reform-minded government and bonds with short maturities at an attractive yield. Currently, India represents our largest country allocation in the fund with a weighting of almost 14 percent.

What role do political and geopolitical risks play when investing in emerging markets?

A very big one. There is no question about it. We must always keep an eye on both the political and geopolitical situation worldwide and the impact this could have on the emerging markets we invest in. The current environment shows this very vividly. To a large extent, emerging markets have been divided into commodity importers and exporters after the sharp rise in commodity prices post the beginning of the conflict in Ukraine. The geopolitical landscape factors into our overall macro view and the choice of geographies we invest in.

Is this the reason why you see opportunities in the oil exporters?

Yes. Entering 2022 we held a positive view on oil prices, but the conflict in Ukraine has created extra impetus here. Of course, higher oil prices benefit a number of emerging markets and we have allocated capital towards these opportunities. We currently see value in the Nigerian sovereign and banks and the Angolan sovereign. Furthermore, the Middle East is a significant beneficiary of higher oil prices, and we see value in select sovereigns and corporates within the region.

In July 2022, the portfolio held 47 percent of its assets in corporate bonds, almost 27 percent in government bonds and a large amount in financials. Does this allocation usually remain within this range?

No, we retain a high degree of flexibility and adapt the portfolio to the respective market conditions we encounter. The fund incorporates the team’s best ideas from across the entire investment universe and this means allocations can change markedly from one period to the next. However, given the rates environment in H1 our focus has been on short-dated bonds which are generally more defensive. Much of our financials exposure is to event-driven ideas across the capital structure and as discussed earlier we have also focussed on emerging market government bonds which directly benefit from higher commodity prices. This places us in a good position in this uncertain and inflationary market environment. And despite a duration of less than 2.5 years, the yield on the fund is an attractive ten percent (circa).

A strong return for such short duration. Is this one of the reasons that you believe that an allocation to emerging market debt should be considered?

That's exactly how I see it. We believe emerging market debt represents an opportunity for every portfolio from a return and diversification perspective. Remember, the emerging markets account for roughly 60 percent of the world’s GDP now. Furthermore, our track record shows that we can add real value through the investment framework we have developed. With our absolute return approach, being aware of the volatility profile of emerging markets and always having an eye on risk, we can offer a very attractive risk return profile in the fixed income segment. This is an exciting investment opportunity in challenging markets.