An interview with Michael Gradl, Head of Fixed Income Structured Products and Spread-Investments at BVK - produced as part of the Investing in Fixed Income, Europe 2017 Report.
At BVK, how do you invest in emerging market bonds?
We hire external partners to invest in several emerging market bond strategies. Especially in fixed income, we tend to manage more in-house than in other asset classes.
For Emerging Market Debt (EMD), if you look at individual countries and the political landscape, you will see massive differences between them. That is why we think partnerships with external managers are more beneficial for our beneficiaries. We have several external managers who invest in EMD hard currency, local currency, and corporate debt. We do like managers who stick to their convictions and not follow short-term consensus. We prefer managers who outperform the benchmark in the long-term.
In terms of collaboration, we believe in a close partnership and monitoring the strategy and results very closely.
From your perspective, can we expect to see a surge towards emerging market bonds?
A rising rate environment in the USA might put some pressure on the local currency. Therefore, a surge is not expected by any of our asset managers. Even so, there is some downside risk still present, we do see emerging market debt as a diversifying factor in our asset allocation and as a long-term investor, we do not plan to change our allocation to emerging market debt significantly.
Lastly, our experts believe that the economic fundamentals of many emerging market economies have not deteriorated as much as many believe, therefore the likelihood of a new “emerging market crisis” is significantly lower than may be currently priced in the market. Any trigger for a new emerging market crisis are absent, such as hyperinflation, large current account, deficits, corporate or government indebtedness, or country specific factors leading to capital flight, downgrades and collapse.
What do you believe currency and bond markets reacted in the way they did in the wake of the ‘Leave’ victory, with a sudden re-price of the risk emerging markets posed?
Local currencies were certainly one of the winners since the June 23rd referendum until the election in the USA. Still, we are enjoying double-digit returns on a yield to date basis.
The actual effect Brexit has had on emerging markets is difficult to determine; we do not see a direct impact on emerging markets, as long as the process the UK follows to leave the European Union does not affect the global economy.
It is still too early to predict the outcome of the Brexit negotiations and the influence on the global economy.
How is this current market uncertainty impacting investors who allocate significantly to emerging markets?
Central banks, especially the European Central Bank and the Band of Japan, are still supportive of the market and therefore have been shown as a stable anchor within the markets. They are currently reducing market volatility. However, there would be some impact if the central banks decided to scale back their programs. That would mean some weakness to EMD, but our asset managers do not expect a significant impact.
In 2016, we saw weakness early in the year, then the UK referendum and then the summer period, where not much has be done in the primary markets. With another bout of uncertainty created by the Trump victory, issuers have remained quiet.
What steps can be taken to counter risks that are heightened in emerging markets, such as political and economic instability, and different accounting standards?
That is exactly the point why we have decided to invest through external managers. Our experts stay on top of any accounting standard differences and address them, even though it is regarded as a very time consuming process. Political and economic instability are the defining characteristics of emerging markets countries.
If you decide to invest in EMD local currencies, then the risk of exchange rate devaluation is certainly one of the highest concerns you may have if not the riskiest part of investing in the asset class. On the other hand, we see the default risk limit for sovereign risk, because of the tool to create local currency to repay debt. We do not currently have much experience with investing in EMD local currency corporate debt. However, we expect that the default risk has to be considered. That being said, the devaluation risk is still the largest risk in our local currency investments, if we evaluate the emerging market strategies managed by our partners.
As a long-term investor, we tend to be in line with our strategic asset allocation with tactical overweights and underweights. We currently evaluate the possibility to add a further EMD asset manager to our allocation, especially in EMD corporate debt.
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