Last summer Argentina pulled off a bond sale that would have been unthinkable just a year earlier. The Latin American country surprised the market by issuing $2.75 billion of bonds maturing in 100 years, with an 8% yield that made it irresistible to investors. Reports at the time show that it was heavily oversubscribed with orders for the bonds going up to $9.75 billion.
Argentina is still considered a “frontier market” by the MSCI, and it was the first junk-rated country to issue so-called “century bonds”. Luckily for Argentina, investors have short-term memories when it comes to the search for yield. The country sold the bonds a little more than a year after it had settled a $100 billion default with disgruntled creditors that had spanned over a decade.
While investors were not necessarily taking a 100-year bet on Argentina’s ability to pay – with an 8% yield the bonds should repay their notional value by 2029 – it certainly shows how difficult investors have found it to satiate their risk appetites. After all, Argentina has been a serial defaulter.
Some of the bonds’ popularity can be attributed to the election of “Wall Street-friendly” candidate Mauricio Macri in 2015 that spelled the end of a 12-year populist movement in Argentina. The country’s shift in political regime has played a key role in its transformation from ‘in default’ to ‘in demand’.
Equity vs debt
David Tawil, president and co-founder of Maglan Capital describes it as “a story of rebirth.” The firm, which invests almost exclusively in Argentina, believes that the ingredients for success exist. “The broader issues regarding leadership and policy changes are quite clear. There is much more economic reform that needs to happen, they have running inflation and there is a fair amount of deficit they need to tackle, but the mechanisms to solve these problems are there,” he said.
The Maglan Distressed Master Fund was down 1.46% in 2017 but tends to have seesaw returns with performance last year ranging from a 7.45% gain in January to a 13.83% loss the subsequent month.
Tawil began investing in Argentinian debt four years ago but has since exited the position. He is now wholly invested in its equity market. This move away from debt into equity represents a significant shift in market logic.
Jeremy Grantham, the co-founder of Boston-based asset management company Grantham, Mayo, Van Otterloo & Co., goes as far as to say that he would hypothetically bet his life on emerging market equity.
“I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death. I believe only a very large investment in EM equities will give an excellent chance of survival,” he writes in GMO’s third quarter letter for 2017. GMO’s equity holdings are heavily weighted toward Asian countries like Taiwan, China and Korea.
Emerging market debt has historically been a Wall Street favorite, generating high yields relative to alternatives in developed markets. But with high yield comes high risk and sovereign defaults are not hard to come by.
Hedge funds are still waiting for Venezuela to pay up on $1.7 billion worth of bonds, three months after it defaulted and with the next maturity date fast approaching. Venezuela’s economy has collapsed and bondholders are unlikely to receive payments for a long time, if at all, thought that hasn’t stop managers from wanting another bite of the apple.
Tawil is monitoring the situation in Venezuela and looking for an opportunity to go in. “For me it’s not about a number, it’s about an event,” he says. He is hoping for a regime change that will follow the paradigm set by Argentina.
Notwithstanding obvious outliers, the spread between bonds in emerging economies and those in developed markets has narrowed, and corporate valuations in developing markets are starting to creep up. Some market players became concerned that valuations had risen too high after the MSCI Emerging Markets Index surged 30%.
A Morgan Stanley report on the outlook for emerging markets debt states that “the narrowing spread differential between EM corporates and their developed counterparts have led to concerns over how much higher valuations could go.”
However, that is not to say that there are no longer opportunities in emerging market debt, rather investors will just have to work harder to find them.
“There are some concerns that emerging market debt is looking stretched, but the tailwind has been that most of the emerging market issuers have been focused more on local currency, and they have diversified their source of funding,” said Alper Ince, a managing director at Paamco, which allocates to hedge funds.
Local currency debt markets have developed into a favored asset class among foreign investors with emerging market governments increasingly issuing debt denominated in their local currencies rather than the U.S. dollar.
Morgan Stanley researchers echo the sentiment in their report, which maintains that valuations are tighter than in the past but local rates are still compelling with real differentials versus developed markets “near maximum levels.”
Meanwhile, Lazard Asset Management remains bullish on both debt and equity markets, according to its recent Outlook on Emerging Markets report. However, the asset manager acknowledges that opportunities are likely to be more idiosyncratic, and that there are two potential macro risks lurking in the form of central bank policy and a slowdown in global growth. The Lazard Alternative Emerging Markets Fund, which invests in EM hedge funds, was up 18.98% last year, its best performance since inception.
Absolute Return tracks the performance of funds investing in Latin America, which have posted stellar performances both in debt and equity. The Absolute Return Latin American Debt Index was up 13.4% last year, delivering its best performance in almost a decade, and it gained 1.24% through January. The Absolute Return Latin American Equity Index almost doubled its counterpart in 2017, returning 22.82%. It is up 2.10% through January.
The Latin American indices were two of the best performing in the Absolute Return universe last year, and asset flows moved in tandem. One notable example being the Moneda Latin American Corporate Debt Fund which welcomed just under $1 billion in inflows last year, boosting its assets to $3 billion, according to Absolute Return data. The fund was up 16.36% last year, and 21.98% the year prior.
Private credit vs public credit
Some investors want to find alternatives to fixed-income assets. “I think what people are missing here is that for 30 years the safest part of a portfolio was the fixed- income portion,” says Robert Koenigsberger, chief investment officer of Gramercy Funds Management. “Today’s challenge is that one of the biggest risks in a portfolio is ‘the safest part of the portfolio’. That’s why I get back to private credit as an alternative asset because it’s less about a bet on rates and much more about credit and the value of the underlying collateral.”
Koenigsberger feels that he can be more adequately compensated by private debt instruments in the current environment, but if a quick dislocation was to occur he could change his mind “very quickly.”
“What we are finding in the private credit markets is this notion that you get explicitly compensated for the illiquidity that you’re providing an issuer as opposed to the public markets where you are definitely not getting compensated for the potential illiquidity,” says Koenigsberger.
The difference lies in the spread between a country’s risk-free rate – the rate of return for an investment with no risk of financial loss – and corporate bond yields. “If you look at Argentina, which has been a fantastic place to be invested in over the last three years, the risk-free rate has rallied from 15% to 5% or 6%, and it has brought the entire public corporate market with it,” he says.
If a company in Argentina issues a bond at 7% and the country’s risk free rate is 6%, it means that an investor is only being paid 100 basis points for all the embedded risks in the bond such as credit and liquidity risk. But if a hedge fund offers private credit to an emerging market corporate, it can request what it considers to be adequate compensation for any risk it is taking on. Moreover, it can request security as a way to protect itself against a potential default.
Receiving adequate compensation for illiquidity is important for hedge funds in emerging market corporate debt as those assets become extremely difficult to sell during a crisis.
Some investors thought the problem had been solved with the emergence of emerging market exchange-traded funds, which are highly liquid instruments when the market is “normal” but when prices come down, liquidity is simply no longer there.
“The mistake they made is [to] believe that having one-day liquidity in the ETF means the underlying portfolio has one-day liquidity. That is where the big mismatch resides in our market, and that is where all the growth has been in the market. I would argue that ETFs are the wrong vehicle for deploying capital in emerging markets and corporate credit,” says Koenigsberger.
ETFs have outperformed active managers in developing economies on the back of synchronized global growth and rising earnings. The MSCI Emerging Markets Index was up 37.28% in 2017.
But this could be about to change as the market starts to see fuller valuations and certain sectors become more crowded thereby calling for a more nuanced approach.
“You have to pick your spots in the market carefully. This year is going to be more about the stocks than the overall indices,” says Ince.
Directional vs tactical
Allocators to hedge funds have begun moving away from directional strategies, especially those that are long biased. Directional strategies take net long or short positions respective to how they think the market is going to move, while long-biased funds are heavily weighted towards long positions. The latter tend to work particularly well when the market is up.
“Long biased would have done very well in the last three or four years, but going forward we think there will be increased volatility across all markets led by the Fed and the U.S. so our preference is for managers that can run both a long and short book,” said Rob Christian, senior managing director at K2 Advisors, which allocates to hedge funds.
Hedging in emerging markets is not as straightforward as it is in developed markets. Borrowing stocks is expensive and sometimes not available at all. Some of K2’s managers have opted to register a legal structure on the ground which increases access to liquidity and reduces costs, says Christian. However, it’s a capital intensive and time-consuming process, he points out.
Alternatively, emerging markets have a liquid and futures market for equities that managers can use, but this does introduce some form of basis risk according to Christian. The value of a futures contract is not necessarily guaranteed to move in line with the underlying exposure.
Paamco’s Ince expressed a similar preference in managers. “We primarily prefer long/short equity, and we also feel fixed income relative value in emerging markets is an efficient strategy that has worked well for us. We have been staying away from heavy directional strategies,” he says.
The consensus among investors is that emerging markets should be able to manage economic turbulence better than ever before, having improved both politically and economically. And more importantly their current account deficits have narrowed.
During the taper tantrum of 2013, outflows were mostly driven by currency volatility in emerging economies that were heavily dependent on foreign capital. Since then, various emerging countries have taken great pains to make their funding deficits more manageable.
“Emerging markets are less levered in general now. There is better corporate governance, better government and they are less tied to developed markets. They need global growth to do well, but they are less dependent on any one developed market,” says Christian. He considers some market volatility to be beneficial as it creates opportunities to buy dislocated securities.
However, the asset class is still facing internal and external political risks.
Latin America has a turbulent year ahead with elections in three major economies: Brazil, Mexico and Colombia. And Mexico faces the added risk that the current U.S. administration will pull out of the North American Free Trade Agreement.
Past outflows are not necessarily indicative of future reactions, but there have been two events in recent memory where the anticipation of Federal Reserve monetary policy normalization has caused turmoil in emerging markets – Alan Greenspan’s unexpected rate hike in 1994 and the more recent taper tantrum of 2013.
Markets in Latin America fell sharply in 1994 after the Fed, led by Greenspan, increased short-term interest rates by 200 basis points in just four months. It triggered one of the biggest drawdowns in emerging market assets that financial markets had experienced.
Two decades later, emerging markets recoiled at the prospect of a Fed retreat from quantitative easing. Shortly after Ben Bernanke first posited the idea of “tapering” the Fed’s asset purchasing program, emerging markets once again suffered huge outflows as the price of sovereign bonds tanked and currencies depreciated.
It is not difficult to draw parallels between these two events and where the Fed finds itself now. The U.S. economy was recovering from a deep recession in both instances, and the Fed was preparing to tighten monetary policy after a period of sustained economic growth driven by record low interest rates.
As the Fed looks to offset its economic footprint for the third time, by reducing its balance sheet while simultaneously increasing short-term interest rates, investors are expecting that emerging market reactions will be measured.
If inflation in the U.S. gets out of hand, emerging markets could suffer. “It [a rate hike] will create volatility if it leads to the U.S. dollar strengthening or if inflation gets out of control in the U.S. That hasn’t really happened yet, but the cost of funding could increase in emerging markets,” says Ince.
While the Fed has attempted to be transparent about its approach to monetary policy over the next two years, the biggest risk is that regulators will get behind the curve and have to hike rates faster than expected.
The Lazard report states that “a dramatic change in central bank guidance toward significant monetary policy tightening because of rapidly increasing inflation” could pose one of the biggest macro threats.
The markets got a taste of this at the beginning of February when reports of strong economic growth and rising wages in the U.S. fueled concerns that the Fed would increase rates faster than expected to fend off rising inflation.
Emerging markets started to see outflows as the 10-year Treasury yield inched up to 2.9% and investors withdrew from riskier assets. On February 8, JP Morgan wrote that emerging market bonds were vulnerable to further outflows in the near term “amid risk-off market conditions.” It further stated that “outperformance of EM assets may make investors nervous that EM may be next for a larger correction but we do not expect this, although retail outflows should be expected in the short-term.”
A slowdown in global growth poses further risk to emerging markets, arguably more so than rising interest rates, according to some managers. “What will really scare the market is any kind of weakening in the U.S. economy,” says Márcio Appel, the founding partner of ADAM Capital, a $7.7 billion Brazilian hedge fund. “The rest of the market is already positioned for this [expectation of rate hikes] scare. It is now common sense.”
But it is difficult to evaluate whether interest rate risk has been adequately priced in considering how long the markets have spent in a low interest rate environment.
“I think that the bullish attitude has an assumption that with higher interest rates you won’t see outflows,” says Koenigsberger, “and to me that is a bit of a stretch.” Much of the performance in emerging markets has been driven by technical factors, therefore flows are a major risk to the asset class, he continues. “When we have outflows, this market will feel less like a market and more like a bazaar.”