The past couple of years have not been kind to emerging market debt fund managers. For many consecutive quarters the asset class was out of favor.
Then, investors’ unrelenting hunt for yield resulted in six weeks of strong inflows between June and July, which were followed swiftly by warnings of a bubble.
Such swings in favor and indeed fortune are nothing new in this sector, and Colm McDonagh, head of emerging market fixed income at Insight Investment, a BNY Mellon subsidiary, is no stranger to the caprices of the market.
‘I do remember thinking after the Asian crisis, the Russian crisis, the Argentine crisis and then the Brazilian crisis that perhaps I should have picked a different career,’ he jokes.
‘But it is fascinating. I’ve always loved the added factors that are required to assess risks in emerging markets. They give an investor a lot of opportunity to generate returns if you manage your risk.’
It is perhaps not surprising then that McDonagh, who runs the BNY Mellon Emerging Markets Corporate Debt fund, is not concerned by fears of a bubble emerging in his chosen asset class.
‘EMD is under allocated to as an asset class, and now people are putting cash to work because they want some positive yield,’ says McDonagh, who also runs the firm’s long/short emerging market macro fund. Fundamentals also still support the current market valuations, he adds.
‘I would be concerned if you began to see a return of some of the issuance strength that we saw previously. Particular companies or countries issuing at levels that you might be questioning due to the fundamentals – and that’s because of the dash for yield.’
Investors have poured $18 billion into emerging market bond funds year-to-date, according to Bank of America, but McDonagh is wary that some investors fail to distinguish between good and bad emerging market debt.
‘I think investor behavior continues to be cyclical and continues to lump emerging markets into one asset class, so it makes no distinction between investment grade, low volatility issuers both on a country and corporate perspective versus those known as frontier markets, which are much more volatile and have many more problems.’
Understanding these differences and navigating accordingly has helped McDonagh’s fund return 23.5% over the past three years to the end of July. Its Citywire-assigned benchmark, the BofA Merrill Lynch EM Corporate Plus TR, has returned 15.4% over the same period.
McDonagh’s analysis begins by studying countries’ political and economic environments before evaluating specific corporate issuances, placing a strong emphasis on value.
Top of his checklist is any planned reforms. Many emerging economies are beginning to understand that reforms can improve their economic and political prospects, he says, with China, Mexico and Argentina all good examples.
Fending off the vultures
The latter’s new market-friendly President Mauricio Macri has already implemented a tax amnesty on top of resolving a dispute with so-called ‘vulture’ hedge funds dating back to Argentina’s 2001 default.
‘The change in political structure and the actions of the existing government have dramatically changed the landscape for Argentina which should – if sustained – unlock lots of inward investment and opportunity from a government and corporate perspective.’
Ireland-born McDonagh has spent his whole career investing in emerging market debt. One formative experience he recalls is the 1997 Asian financial crisis, which was triggered by the collapse of the Thai baht.
‘Post the Asian debt crisis, we looked at a lot of corporate names that were trading at very distressed levels. Some of the lessons I learned then about company structures, bond documentation and legal structures are an integral part of the process we still use today,’ he says.
Understanding what is happening across these countries at a macro level is vital, and he is willing to substantially underweight the benchmark if certain bonds are not worth the risk.
When Russia’s economy was struggling because of low oil prices and its conflict with Ukraine, McDonagh cut the fund’s Russian exposure.
‘Our take is that if the country is deteriorating then we have zero corporate exposure. Corporates are a derivative of the government bond market of each country,’ he says.
Once a country looks stable, McDonagh, who can call on the analytical skills of a 23-strong team, takes a bottom-up approach and compares corporates on a global basis.
For example, if there is a Brazilian telecom name that sticks out, he’ll look at it in comparison to names in the US or Europe, not another emerging market company. It’s a key defining factor, he says.
‘We prefer to have either an underweight or zero exposure if things are too expensive. If things are considered risky, we are here to price that risk,’ he says.
However, in emerging market corporates it’s important not to be blinded by attractive valuations. ‘You have to be aware of what’s happening in the macro space you can’t take a complete value approach at it.’
The quality breakdown of the portfolio is currently 60% in investment grade, 35% in high yield and the remainder in cash.
Having enough liquidity in the portfolio is another foundation of his approach, as it gives flexibility.
‘Late last year we were concerned about valuations in relation to fundamentals. We were underweight duration, underweight high yield, and that actually hurt us a little bit, up until December when markets had a little dip.
‘But then, having that flexibility – that liquidity – gave us the ability to go in and buy some assets that we felt were pretty cheap, and hence we have managed to outperform significantly this year.’
McDonagh’s fund beats the index over three years
McDonagh took advantage US high yield’s rally this year to acquire a number of emerging market oil and gas companies, ramping up his now overweight position as he felt many were trading below fundamental value.
The firms he holds include Indonesian state-owned Pertamina, Russian oil giant Lukoil, the State Oil Co. of Azerbaijan, Mexican state-owned oil firm Pemex and Brazil’s scandal-hit Petrobras.
McDonagh says he picked up Petrobras at distressed levels earlier this year, and it has been a portfolio driver since.
‘One thing we spent a lot of time on and has generated some good return for us is Petrobras,’ he says. ‘What was interesting were the steps Petrobras took to sell some assets and rejig its balance sheet and deal with its debt issues.’
In his investment grade allocation, McDonagh is long duration in Chile, specifically in retailer Cencosud.
After oil and gas, telecoms make up the second largest sector in his portfolio holding with names such as VimpleCom in Russia and Millicom and Digicel in Latin America.
In contrast, the largest sector in the benchmark, financials, is a major underweight.
‘That’s mainly because in financials we don’t think we’re being compensated for the risk, and in some cases we had begun to see a deterioration in the quality of the loan books from some of the banks. This affects India and parts of the Middle East.’
This article was originally published in the September issue of Citywire Americas. To sign up to receive our free magazine, follow this link.