Local currency emerging market debt is one of the few areas of the fixed income market where it is possible to find mispriced securities with high yields and relatively low default rates, according to Ninety One’s John Stopford.
Stopford runs the Ninety One Diversified Income fund, which aims to deliver a defensive total return with a yield of about 4%, regardless of what is happening in equity markets.
This has become challenging since the financial crisis, with bond yields at record low levels. In addition, Stopford is averse to holding many of the major dividend payers in the UK, pointing out most of them operate in structurally challenged industries.
However, one area he said still offers value is emerging market debt.
“We think there's an opportunity that isn't appreciated by markets,” said the manager. “If you invest selectively, you are paid a very large risk premium because they come with this emerging market label.
“We’re not just going out and buying everything, we are selecting individual markets that have the characteristics we're looking for in terms of yield resilience, in terms of cash flow supporting that yield, and then other positive risk premia.”
Investing in local currency emerging market debt isn’t without risks, such as the potential for a collapse in the currency, which can wipe out a UK investor’s return, even if the bond itself doesn’t default.
The Turkish lira has more than halved in value over the past five years, for example.
However, Stopford said that this threat can be removed by simply hedging the currency back to sterling, leaving these instruments with a risk profile similar to that of their developed market counterparts.
“You end up with a high-yielding asset that's essentially issued by a government of decent quality paying a large risk premium,” he continued.
“Historical default rates are very low. We're talking about somewhere like Indonesia issuing in Indonesian rupiah, so the default rate is much lower than somewhere like Argentina which borrows in dollars and basically has no taxing capacity in dollars: it is entirely dependent on its ability to generate dollar revenues from economic activity.”
Asset class ratios
Source: Ninety One
Stopford’s co-manager Jason Borbora-Sheen added that the spread between emerging market local currency and developed market bonds was still above pre-financial crisis levels.
“There are not many asset classes where you can say that,” he said.
“Then when you remove that currency risk, you end up with a Sharpe ratio that is in excess of developed market government bonds. I think that is quite an attractive way of finding fixed income opportunities that are reliable outside of very expensive gilts and European bond markets.”
However, it is an unusual time to hold a significant fixed income allocation – the market has begun its early stage of the economic cycle, which is often the best time to buy equities.
Stopford pointed out that most equity markets have already rebounded to pre-pandemic levels, meaning they have priced in much of the recovery.
In addition, he said that governments and central banks had begun to talk about removing some of the policy accommodation they used to underpin economies during the pandemic. This, said Stopford, has increased the risk of a correction.
“One of the things we have noticed over the past decade or so is you have seen more severe and more frequent equity market drawdowns than you saw prior to the global financial crisis,” he continued.
“We think part of that is linked to lower market liquidity generally, which tends to exacerbate market moves, and some crowding of positions as everyone adopts the same ideas. Also, a lot of positions have been taken through passive vehicles.”
He added that a “distorted global economy”, where themes such as ageing populations and high debt levels have undermined growth at the same time as very extreme monetary and fiscal policy from central banks has tried to keep it ticking over.
“The tension between those large forces means that inherently, markets are unstable and every so often that manifests itself in these severe market drawdowns,” he said.
Borbora-Sheen pointed out that the fund tends to perform relatively well in these environments, falling by just 11.6% last year, for example, compared with 32.73% from the FTSE All Share.
Performance of fund vs index in 2020
Source: FE Analytics
The FE Investments team agrees with him, which is one of the reasons it added Ninety One Diversified Income to its Approved Funds list.
“The fund provides a strong solution to investors with a clear income target,” it said.
“Due to its mixed asset, but also defensive, approach, we have been impressed by the capacity of the fund to generate this stream of income, irrespective of the directions of equity and bond markets and believe it is acceptable to consider the fund as an alternative asset in a portfolio.”
Data from FE Analytics shows Ninety One Diversified Income has made a 48.9% total return since Stopford joined in July 2012, compared with 86.6% from the FTSE All Share and 43.1% from the IA Mixed Investment 0-35% Shares sector.
Performance of fund vs sector and index under manager
Source: FE Analytics
The £1.6bn fund has ongoing charges of 0.79% and is yielding 3%.