Bond investors’ fear of the emerging market high yield debt sector is misplaced, according to Dimitry Griko, chief investment officer of fixed income at EG Capital Advisors, who says it offers higher yields than its developed market counterpart with lower risk.
The latest data from the Investment Association shows that IA Global Emerging Markets Bond is the second smallest fixed income sector, behind only IA UK Index Linked Gilts.
Griko is well-aware of the poor reputation of emerging market high yield among investors, due to a perception of “low liquidity, high volatility and high correlation with other riskier asset classes”. However, he said that the data tells a different story.
“In reality, there's quite a lot of value,” he explained. “When you look at emerging market high yield, it actually has lower volatility than, for example, developed market high yield, it has lower correlation to, for example, developed market equities than developed market high yield and so forth.”
As this is a fixed income fund, Griko said that the real risk to investors is not short-term volatility, but defaults on its underlying holdings.
However, data from Bank of America Merrill Lynch shows that since the turn of the millennium, default rates in emerging market high yield debt are lower than for its developed market counterpart.
“And at the same time, the recovery rates as calculated by JP Morgan are on the same level and we get paid more in terms of yields,” the chief investment officer added. “So, we get paid more for lower risk, which is amazing.”
Griko said that the perception that emerging market high yield is a riskier asset class can even work in his favour. For example, when the market is “risk-off”, global investors tend to indiscriminately sell anything related to emerging markets, which creates highly correlated volatility – frequently allowing him to pick up quality positions for less.
This is not to say that he is complacent about the risks in this asset class. Instead it is quite the opposite, with the manager pointing out that properly managing risks is the obvious way to add value.
“The structure of the market by itself is quite risky, for example, almost 30 per cent of emerging market high yield is financials,” he explained.
“And what are financials? These are the names that are most sensitive to an economic downturn. These are the names that have pretty much zero transparency in terms of what's on their books, and what kind of risks they're carrying. And these are the names that in the worst-case scenario have pretty much zero recoveries, just because of the nature of the leveraged business.
“And 20 per cent of that is China which is pretty much over-levered, overvalued real estate. So, we really believe that the portfolio has to be managed in a conservative manner.”
Despite the risks he has identified from individual regions and sectors, Griko and his team take more of a bottom-up approach. So, while they are pessimistic about the situation in Turkey, this won’t cause them to automatically avoid Turkish companies – instead, they will price-in a worst-case scenario. For example, they will only hold companies that could still service their debt in dollars were the banking system to go bust.
Instead, Griko prefers to focus on the fundamentals of a business – paying close attention to its financial health.
“We don't just take the accounts for granted, there's a lot of search for fraud over there,” he said.
“There's a lot of adjustments, because there's so many accounting tricks out there, which can make a company look good when in reality, the cash is not really there.
“I mean, you can make a profit in 20 years and count it for this year, but the cash is not going to be there.
“We adjust everything to a cash-flow basis, standardise and do our relative values properly. We spend a lot of time analysing the capital structure and the legal structure of the company.”
“We look at the ability of the company to move cash within the capital structure and within the legal structure. We look at the owners, shareholders and management, in terms of their ability to take the cash out of the company. We spend a lot of time on covenant analysis.
“And just in terms of understanding how we are protected, we look for, you know, any structural subordination and so on and so forth. The actual research project process is very, very intense from that perspective.”
Despite this focus on risk, holdings do occasionally default. However, the team sees loss-limiting as another way to add value: Griko said the average recovery on money lent to holdings in the fund that default is around 63 per cent, compared with 38 per cent from the market.
In several positions that have defaulted, EG has actually been able to make money. Griko noted one example of a company whose entire operations flooded.
“We understood that the business was very viable and once they got their licences it was going to work,” he added.
“We basically bought the bonds at 30 cents on the dollar and sold them at closer to 70 per cent. It really played out well. I mean, these are individual stories, but it's just a matter of understanding the fundamental value of the company.”
Data from FE Analytics shows the EG Emerging Markets Corporate High Yield fund has made 14.88 per cent since launch, compared with 5.62 per cent from its Off Mt Fixed Int Emerging Markets sector.
Performance of fund vs sector since launch
Source: FE Analytics
It is $233m in size and has an annual management charge of 0.9 per cent.
According to its most recent factsheet, it is yielding 6.82 per cent.