The tailwinds for alternative fixed income strategies in emerging market debt

The tailwinds for alternative fixed income strategies in emerging market debt

by Anthony Kettle, Senior Portfolio Manager.

The market, currently, is favourable for EM alternative fixed income, largely, because we're in an unstable environment. If you think about politics, if you think about economics, there is uncertainty. When you have uncertainty, typically, you have volatility in markets. That's not common only to EM. I think you're likely to have uncertainty which impacts markets across the board this year.

When you think about emerging markets, what can be more unique is the fact that we're looking at 80 different countries, 13 different sectors, 500 different companies within this asset class, multiple different currencies. What that means is, when you have volatility, when you have uncertainty, you can also have heightened levels of dispersion.

Being able to approach that dispersion from the point of view of being long, but also of being short, really maximises the opportunity set. I think emerging market debt is attractive for absolute return investing, because when you think about indices, typically, they're not the most efficient way of allocating capital. What we find in debt markets is, the more debt you issue, the more that becomes, in terms of the weighting within each index, and the more that attracts capital from indexed, and particularly, from passive investors.

That creates significant amounts of inefficiency when you have an asset class which has more than 80 different countries within it, and more than 500 different companies. Looking at alternatives which are able to simply look at the best ideas, both on the long side, so where is the best place for me to allocate capital? As well as the best ideas on the short side, what are the least worthy places for me to allocate capital, and where can I actually make money from negative price action?

This creates a very large opportunity set, and it really allows you to capitalise on the inefficiencies which are driven by the standard market structure. The alternative side of EM fixed income has been growing in complexity, and so there's many different ways in which you can access it. I would typically break it down into unconstrained type investing, and that would be generally long biased, and more liquid in terms of the fund profile.

Often, daily liquidity, but unconstrained, in the sense, that it doesn't have reference to a specific market benchmark. It is really looking at returns of cash plus a specific amount. In the guidance, I would say something like cash plus 4% to 6% as a potential reference benchmark to look at, looking at everything within fixed income, hard currency assets, as well as local currency assets, but with the ability to also express short views via derivatives.

That would be one way to get around the issue of indices, ultimately, attracting capital to the largest issuers, as opposed to the most credit worthy issuers. The next step I would call absolute return investing. The idea here would be to generate a certain level of return every year, which would be a positive, despite potentially negative markets. Throughout market cycles, it would have a positive return.

Really, there what you're looking for is an all-weather fund that is able to have different strategies within it that can perform in different market environments. Therefore, if you're allocating capital correctly within the fund, different strategies will be performing at different times, and ultimately, the correlations will mean that you end up with positive total returns at the end of the year.

This we would call, typically, long-short investing in the emerging market credit world, and that is really benefiting from some of the inefficiencies within the asset class, and the fact that there are limited amounts of funds which are actually able to perform long-short investing, because of the natural barriers to entry there.

Finally, I would look at the least liquid part of the asset class, which would be the loans, typically. Looking at illiquid credit within the emerging markets, and typically, there that is looking to capitalise on the illiquidity premium that is available, and we estimate the illiquidity premium to be in the region of 500 basis points, which can be captured within the emerging markets.

We think that they are really the three key areas in which you can look at the alternative framework. There are obviously nuances within that. In terms of the three different alternative strategies outlined, so we have our total return, where we might expect throughout the cycle cash plus 4% to 6% as a guideline for returns. In terms of long-short credit investing, I would say returns net of all fees, somewhere in the region of 10% to 12% is certainly feasible.

In terms of looking at illiquid credit, if we're thinking about gross returns, I would say in the region of 15%, given that 5% illiquidity premium is something that investors could be looking for through the cycle. I think in terms of the differentiators for us, if you look at the fund product lineup that we have, we have everything ranging from traditional long-only funds in the sovereign space and the corporate space, all the way through to illiquid credit at the far end of the alternative space.

What that tends to do, is to give a whole market view, because we are seeing all of the opportunities that are arising within the EM fixed income landscape, and that gives us a much better understanding of the opportunities that are available at any particular time.

I would also say that running long-only funds alongside the alternative funds, and I would say that BlueBay has had a history from the early 2000s of running alternatives, means that, we're able to run a very large and well-resourced team, which actually is one of the key barriers to entry to the EM alternative space, but actually is one of the key reasons as well for the level of inefficiency within the asset class. If you can overcome those barriers to entry, you can actually have a very good chance of exploiting those inefficiencies, and delivering strong levels of alpha.