Should We Exercise Caution with Emerging Market Bonds?

Emerging market bonds have been performing well of late, but a top-performing fund manager says he’s treading more carefully.

David Nava, lead manager of the $1.8 billion 4-star silver medalist RBC Emerging Markets Bond Fund, has raised more cash to take advantage of a possible downturn in emerging market bonds. The primary concern: When the yield advantage on emerging market debt is compared to safer US Treasurys – a metric known as a spread – the gap is historically at low levels. That means investors are being compensated less for taking on the risks that come with owning emerging market bonds.

“Emerging market sovereign bonds are expensive, from a historical context,” says Nava, who has been involved in managing RBC’s EM bond assets since 2010.  “This gives me some sense of caution, with the risk that we have in the market,” he says.

RBC Emerging Markets Bond Fund

Nava’s determination to be selective in what is and isn’t an acceptable risk has paid off for investors. Through Aug. 30, RBC Emerging Markets Bond Fund D has returned 7.92%, versus 5.13% for the emerging markets fixed income category. Over three-, five-, and 10-year periods, the fund has been a first- and second-quartile performer. The fund’s strong performance can be pinned on several factors, he says. “Country allocation has helped us. The key is selecting countries where I see an improving trend. Egypt is one of them and a big part of why we have done well this year,” says Nava. He notes that last winter’s election returned President Abdel Fattah El-Sisi to office, and he has been pushing reforms to attract more foreign investment and secured funding from the United Arab Emirates. “We also see improving trends benefiting our positions in Ecuador, Argentina, and Mexico. They have done well, and we have overweight positions in those countries.”

The second factor is the duration weighting, or a measure of sensitivity to fluctuations in interest rates. A lower duration indicates less sensitivity to changes in bonds. Currently, the fund’s duration is 6.5 years, slightly lower than the benchmark’s 6.7 years. “As Treasury yields have come down, the duration component has helped us to generate total returns.” 

The third factor is taking an active position. “It’s always a combination of identifying fundamental trends or trajectories, adopting a position, and making sure that we get compensated for that position,” argues Nava, who relies on macroeconomic data from sources such as the IMF and World Bank to conduct his analyses. “It’s very difficult to identify a beautiful, fundamental story, but when you see how much you are getting paid to hold that story, there could be little or nothing to generate alpha.”

Fed Rate Cuts and the Emerging Market Bond Outlook

The backdrop for emerging market bonds turned positive in 2023 as investors began looking ahead to Federal Reserve interest rate cuts. “The market started to say that, ‘In 2024, we will see lower interest rates, which means lower financing costs for EM countries.’ That’s good for EM sovereign bonds. All these countries can afford more debt, or the default risk will drop, when rates are coming down,” says Nava. “Fast-forward to where we are today, and EM spreads have fallen from 265 bps to around 208 bps. This reflects a less pessimistic backdrop that we had in 2023.”

In effect, Nava observes that the market has switched from a pessimistic outlook to a more benign one, adding that even countries whose bonds carry low ratings of CCC or B have seen valuations rise.

“Yes, the market is expensive, but I still need to be active and differentiate between poor risks and more attractive countries. But I like Vietnam, for example,” says Nava, who is largely a top-down investor, relying mostly on quantitative analysis and partly on qualitative study. “Growth is accelerating this year to 5.8% from 5.0% in 2023 and is forecast to grow 6.5% in 2025. One of the factors I use to differentiate countries is government debt relative to the size of the economy. In Vietnam’s case, there is only 33.5% of gross domestic product in government debt. To put it in context, the average in the EM universe, which includes about 85 countries, is 69.4%.” Although he admits Vietnam’s government is undemocratic and the country has weak institutions, he is holding about 0.5% of the portfolio there.

Conversely, he is very cautious on Venezuela: “In the past 10 years, its economy has shrunk by 71%. Put another way, the economy is only 29% of the size that it was when President Nicolas Maduro took over. The economy has been decimated, and even though they recently had elections, Maduro showed zero signs of relinquishing power. The deterioration in the fundamentals is likely to continue.” About 0.40% of the portfolio is held in Venezuelan bonds, versus 0.61% in the benchmark JP Morgan Emerging Market Bond Index Global Diversified (C$). “Pricing of these bonds is 15 cents on the dollar. At some point, and if we see a re-structuring, we could see a recovery value that is higher. But for now we are underweight Venezuela.”

Valuations Look Expensive

 The fund, which is almost exclusively invested in government or sovereign bonds denominated in US$, is invested in 53 countries. The top 10 countries, ranging from Mexico to South Africa, account for about 35% of the fund. From a credit quality standpoint, the portfolio is overweighted to BB-rated bonds (considered high yield), since about 57.2% of the portfolio is in those bonds. Otherwise, there is 37.6% in investment-grade bonds (a mixture of A-rated and BBB-rated bonds) and 5% cash. “I get better compensation with BB bonds than I do with A and BBB bonds,” says Nava. The fund’s running yield is 5.9% before fees.

One of the bonds in the portfolio is an April 2044-dated BB-rated bond from Dominican Republic, which has a duration of 10.5 years and is yielding 6.51%. “It’s a country that I like and has a well-diversified economy, since they have mining and agriculture in addition to tourism, and it’s growing. Its GDP is expected to grow 5.4% this year,” Nava explains. 

 Another holding is in an Egyptian sovereign bond which matures in January 2047 and is rated B-. The bond is yielding 11.4% and has a duration of 8.4 years. “It’s a riskier proposition [than the Dominican Republic], but we are getting compensated for the risk,” Nava says. Both these positions account for 1.5% each in the portfolio.

Looking ahead, Nava admits that he has some worries. “When we see valuations become more expensive and near the current historically ‘expensive’ levels, there is often a re-pricing that happens. We do not know what triggers it, whether it’s the U.S. economy or presidential elections or China. But it is a concern. We move in cycles, and right now we are in the part of the cycle that is expensive. For sure, if we get a repricing and spreads go from 200 bps to 300 bps, that will lead to a negative return.”

To guard against potential turmoil, Nava has been accumulating cash and reducing riskier positions, mostly in African countries such as Kenya and Senegal. 

At the same time, he is preparing for the day when prices are more attractive and valuations are cheaper. “Yields will go out, and spreads go higher. For me, that’s my sweet spot, because I can reposition the portfolio into holding maybe riskier credits. But we’ll be more compensated than we are right now. The key is to not be afraid to be active when the opportunities come up.”

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