Pimco Emerging Market Debt Investment Opportunities and Challenges

Pimco's emerging market debt investment strategy has been successful in navigating the complexities of these markets, with a focus on high-quality issuers and a diversified portfolio.

Pimco's research suggests that emerging market debt offers attractive yields compared to developed markets, with an average spread of 350-400 basis points over US Treasuries.

Investors can benefit from Pimco's expertise in identifying opportunities in emerging markets, such as Brazil and Mexico, which have shown resilience in the face of economic downturns.

A key challenge in emerging market debt investing is country risk, which can be mitigated through careful selection of issuers and a focus on high-quality credits.

Investing in emerging market debt can be a high-risk, high-reward proposition. Mark-to-market efficiency of returns along the quality spectrum is a key factor to consider, with metrics like the Sharpe ratio showing a lower risk-adjusted return for EM debt rated single B and CCC.

The Sharpe ratio indicates that EM debt is more volatile, especially in the lowest-quality bonds. This means investors may experience greater losses during times of market stress.

Drawdowns, or the decline in value of an investment, are disproportionately deeper for EM debt during acute stress periods. In other words, EM debt can drop further in value than U.S. corporate debt in times of crisis.

The sensitivity to market-based returns, or betas, becomes asymmetric for EM debt. This means the downside capture during a market sell-off is larger than the upside capture during a rally.

The best EM debt investors over the past decade achieved their status by minimizing defeats, not maximizing victories. They experienced 4th-quartile monthly returns only 21% of the time, compared to 38% for the worst managers.

Passive investing, on the other hand, has been remarkably consistent, ranking at the lower end of the 3rd quartile year after year.

Investors can treat EM debt as a structural allocation to de-concentrate from domestic sources of credit risk, and size the allocation based on its effect on the Sharpe ratio of their overall portfolio.

Diversification is key in strategic asset allocation, and for emerging market debt, correlation with a broader portfolio is the most important metric.

The correlation between EM debt and U.S. corporate debt is about 0.63 over the past 10 years, which is relatively low within the world of fixed income spreads.

This low correlation makes EM debt a valuable addition to a portfolio, and it's not just about higher yields.

An asset inclusion test can help optimize a portfolio's Sharpe ratio by maximizing it subject to risk, return, and correlations of individual assets.

This approach can lead to a more sober assessment of sizing in strategic asset allocations, considering the asset's marginal impact on the overall Sharpe ratio.

Many clients, ranging from insurance companies to pension funds, have chosen an allocation of 2% to 8% for EM debt.

The best investors in EM debt had about the same frequency of 1st-quartile monthly returns as the worst investors, but the best investors had a dramatically lower frequency of bad months.

This is because the best investors focused on minimizing defeats, rather than maximizing victories. The best and worst investors had 23% and 21% of 1st-quartile monthly returns, respectively, but the best investors experienced 4th-quartile monthly returns 21% of the time, versus 38% for the worst managers.

Passive investing has been remarkably consistent, ranking at the lower end of the 3rd quartile year after year. The vast majority of active managers perform much better, with better performance that doesn't have to feel like a roller coaster.

Investors can treat EM debt as a structural allocation, used to de-concentrate from domestic sources of credit risk. They can size the allocation based on its effect on the Sharpe ratio of their overall portfolio.

The optimistic stories told by EM investors for decades have been replaced by more nuanced ones, but they haven't always mattered for investment returns.

Investors should not treat EM as a space to hunt for high returns, as it may sound counterintuitive, but the case for EM debt should not be anchored on spreads, yields, or some other valuation metric.

Policymakers are better at business cycle stabilization, but there is greater political and geopolitical uncertainty than before, which affects investment decisions.

Investors should prioritize lower-risk countries with reasonable valuations over high-risk countries with great valuations, and move to more senior parts of the capital structure, from equity to debt, as per Warren Buffett's book.

Catch-up growth continues, but at a slower pace, which has an impact on investment strategies.

The number of investable EM countries has more than doubled in the past 20 years, providing a wealth of opportunities for investors.

There are now about 200 individual macro risk factors across 85 countries, which is a significant increase from what it used to be.

Correlations across this matrix range from 0.8 to -0.7, calculated by PIMCO, indicating extreme diversity within the asset class.

Some factors are "risk-on" while others are "risk-off", meaning they're positively or negatively correlated to global systemic factors like oil or equities.

There are now about 12 sovereign bond issuers that have provided similar portfolio ballast during risk-off events over the past 15 years as U.S. Treasuries.

A basket of EM local bonds hedged to U.S. dollars generated higher returns than comparable U.S. Treasuries over the past 15 years, and had a similar success rate in hedging equity drawdowns.

The rise in available instruments has grown nearly 20-fold in the past two decades, allowing investors to disaggregate country-level macro risk factors into fine granularity.

EM debt used to be characterized by fat tails, but now its distribution of returns resembles that of more mainstream asset classes such as U.S. corporate debt.

PIMCO Emerging Market Debt has seen significant growth in recent years, with assets under management reaching $130 billion in 2020.

The firm's focus on emerging markets has been driven by the increasing demand for debt instruments in these regions, with the global emerging market debt market expected to reach $2.5 trillion by 2025.

One key trend in the market is the growing importance of local currency-denominated bonds, which can provide a hedge against currency fluctuations for investors.

Investors added a whopping $36.5 billion to emerging markets (EM) portfolios in July, according to the Institute of International Finance (IIF).

This influx of capital is a testament to the growing interest in EM markets, which offer attractive valuations and growth prospects.

PIMCO's Emerging Markets Corp Bd Instl fund, for example, has a portfolio allocation of 110.4% in foreign issues, indicating its focus on international markets.

The fund's investment style is high-quality and moderate sensitivity, making it a suitable choice for investors seeking stable returns.

In July, investors were cautious about exposure to currencies such as Brazil's real and Mexico's peso, which have underperformed.

Here's a breakdown of the fund's portfolio allocation as of June 30, 2024:

The fund's expense ratio is 0.93%, which is relatively low compared to its category average.

The fund's investment team has an average tenure of 5.1 years, with the longest tenure being 8.0 years.

Overall, the influx of capital into EM portfolios in July is a positive sign for the market, and investors should continue to monitor the situation closely.

EM drawdowns have been deeper at lower rating levels, making them a riskier investment option. This is evident in the data from Bloomberg, J.P. Morgan, and PIMCO as of 30 April 2023.

The additional risk associated with lower-rated EM debt is not just about the credit risk, but also about other burdens such as unfamiliarity, wider bid-ask spreads, and additional mark-to-market volatility.

EM debt offers higher spreads compared with U.S. corporates despite similar fundamental credit risk, averaging about 70 basis points on a risk-neutral basis over the past five years.

Investors should be aware that these additional burdens can affect their returns, even if they have a long-term perspective.

The return distribution of emerging market (EM) debt has undergone a significant transformation, and it's now eerily similar to that of U.S. corporate debt.

According to Figure 2, the EM return distribution has evolved to resemble U.S. corporate debt, with a rolling 3-year annualized returns chart showing a similar pattern.

This shift is not just a coincidence, but rather a reflection of the changing landscape of EM debt. In fact, EM External, which is roughly 60% investment grade (IG) rated and 40% high yield (HY) rated, is now mirroring the performance of U.S. IG credit.

One key takeaway from this evolution is that the default probabilities for issuers rated CCC are higher for EM than for U.S. corporates. This is largely due to the unpredictable nature of EM debt, where political upheaval can rewrite the rules of the game.

Here are some key differences between EM and U.S. corporate default data:

These nuances are crucial to consider when evaluating EM debt, as they can have a significant impact on investment decisions. By understanding these differences, investors can make more informed choices and navigate the complexities of the EM debt market.

China's economic growth is downshifting, and this has significant implications for the global economy. This shift is likely driven by concerns around U.S. containment policies.

The Chinese government is transitioning away from rapid debt-driven growth in favor of slower but more equitable growth. This will weigh on countries most dependent on demand from China, either directly or indirectly through commodity prices.

Non-energy commodity exporters will be hit hardest by this disruption. China's efforts to contain debt and property investment will lead to important risks to the global outlook.

If China's efforts lead to a recession, currency depreciation could send deflationary ripples through the rest of the global economy. This would put downward pressure on the entire EM currency complex.

However, it's also possible that China's growth downshift could lead to a rebalancing of internal growth and a smaller trade surplus, just like Japan in the 1990s. Japan's share of global growth fell from 24% to 1% during that decade.

China's shift towards consumption over investment could also lead to a similar dynamic, where global growth rates are largely unaffected, but with an offsetting acceleration in other regions.

Accelerated technology adoption is likely to have a significant impact on emerging markets. Accelerated automation is weighing heavily on lower value-added production and low-skilled employment.

Higher unemployment levels may increase social unrest, especially if governments struggle to help reallocate labor to other sectors. The green transition is also expected to add to the rising costs, making it even more challenging to implement reforms.

However, the potential gains from accelerated digitalization are substantial. Accelerating technology diffusion can provide public services and financial inclusion by broadening societies' access to credit.

The key challenge will likely be in providing opportunities for those displaced by the shift.