15 May 2019

Avoid Getting “Caught” by the Tuna Boats: The Importance of Active Management in EM Debt

By Mark Hughes

Emerging markets (EM) debt is a growing and diverse asset class that allows participants to invest in over 70 different countries globally. While this breadth presents investors with opportunities for both diversification and yield enhancement in their portfolios, it also comes with potential credit risk and information asymmetry. As we discuss below, a passive approach to investing in EM debt can leave investors both trapped in deteriorating locales and making unintended structural allocations. As a result, Western Asset firmly believes in the merits of active management for EM debt allocations.

The primary reason to favor active management in EM is for the opportunity to pick winners and avoid losers in a rapidly evolving global economy. For example, passive investors in EM sovereign indices could have gotten caught up in Mozambique’s fraudulent tuna boat financing that led to sovereign distress in 2016. Another demonstration of the perils of passive investing can be seen in Venezuela—a country representing as much as 8% of some EM sovereign indices just five years ago—which is currently undergoing an economic, political and humanitarian meltdown. Leveraging its global research platform, the Western Asset EM team endeavors to avoid capital losses while adhering to our discipline of long-term value investing, focusing instead on a broad credit spectrum of sovereigns with improving fundamentals, such as Indonesia, Egypt and Peru.

Given evolving issuance trends, another reason to be wary of a passive approach to EM debt is benchmark creep. Similar to how investors in popular high-yield ETFs are forced to absorb the inclusion of “fallen angels” (issues downgraded from investment-grade to high-yield) in their passively run products, some EM funds could be forced to purchase whatever the market is selling—regardless of fundamentals or investment merits. Recent examples of this within EM include the explosion of issuance from Middle Eastern issuers, which printed nearly $70 billion of new bonds from Saudi Arabia and its national oil company, Aramco. The proliferation of Chinese corporate issuers over the past five years—now representing as much as 25% of some EM corporate indices—is another reason to not just follow the benchmark blindly. While Western Asset prides itself on its ability to take advantage of attractively priced new issues, the issuers that need money the most are not always the ones you want to lend to.

Passive investing in EM can have serious structural disadvantages that hurt returns. In the popular EM local currency market, indices often specify bonds regardless of tax and/or withholding implications, which can be a drag on returns in countries such as Brazil, Colombia and Indonesia. Where appropriate, Western Asset is able to achieve exposure to these markets while minimizing tax costs and tracking error by using methods such as supranational issuers and FX forwards. Similarly, passive EM products often miss out on one of the best opportunities to find value in the bond market: new issues priced at a concession. Western Asset is able to use its global market presence to receive allocations of new issues priced to sell, while passive structures often are forced to buy in the secondary markets or at month-end. And don’t forget concerns that a shift toward large ETFs could result in liquidity and pricing dislocations for passive investors during times of market volatility.

Western Asset is a strong proponent of an active approach to investing in EM debt. Our global EM team’s number-one goal is to separate the wheat from the chaff amongst an increasing number of EM opportunities. We look forward to speaking with you about our client-focused, customized approach to active management in EM.