Why avoiding this investment could be a disaster

When you think ‘risky’ areas of the market, chances are, emerging markets (EM) rank high. 

But perhaps we’ve all been making a terrible mistake - and missing out on a high-quality area of the market, priced at a discount - particularly regarding fixed income.

“A negative view on EM has been a disaster,” says Eric Fine, portfolio manager for VanEck’s Emerging Market Fixed Income funds. 

To be blunt, EM today is not the EM of the 80s and 90s, argues Fine, adding that it makes little sense from a returns perspective to have been avoiding these markets for the last 20 years. 

He’s seeing major opportunities in this area of the market as a result of two key trends:

1. Re-globalisation

Countries are resetting trade links post covid and this has been beneficial for EM countries.

“EMs are getting positive terms of trade shocks through lower costs with greater trading partners,” Fine says.

2. Continued high-quality fiscal and monetary policy in EMs

According to Fine, it’s not a problem for EM central banks to maintain higher for longer interest rates because these countries have low debt. 

He notes that it is more challenging for developed markets (DMs) because many of them have high debt, and central banks can’t “bankrupt the government.”

In this episode of The Pitch, Fine discusses why investors should rethink their views on emerging markets, the countries he is most bullish on, and three key rules for investors to take into account when it comes to investing in EM bonds. He also discusses why his portfolio has a higher weighting to BBB and BB-rated bonds.

Please note this interview was filmed on Tuesday, 7 May 2024.

Edited transcript

Traditionally, emerging markets' fixed income has been viewed as a risky option. Why should investors revisit this view?

Because it hasn't worked for 20 years. 

For 20 years, our benchmark - which is local currency, government bonds of EMs and dollar-denominated bonds of EMs - has massively outperformed the asset price in fixed income that everyone depends on - the global ag. 

During a period of great change after the Global Financial Crisis, in which debt and interest rates were really prominent, we're up about 172%. The global ag is up about 50%.

So, a negative view on EM has been a disaster for the last 20 years, and I think the conclusion is the market has generally not looked at EM freshly for the last 20 years. It is instead thinking of EM as the EM of the 80s and 90s. The 80s and 90s were bad, but they learnt and fixed themselves. The main point is it hasn't worked to avoid EM for the last 20 years.

What trends are you seeing across the market?

1) Re-globalisation

The world is globalising their new links and these are very positive for EM. EMs are getting positive terms of trade shocks through lower costs with greater trading partners. That's the big thing that the West benefited from for decades.

2) Continued fiscal and monetary high-quality policy in the EMs

EM central banks consistently maintain high real interest rates. For example, recently the Fed went higher for longer. EMs? Not a problem. We'll be higher for longer too. It's not a problem because they have low debt. It's actually a problem for the DMs. The basic problem with high-debt countries is you can't really have an independent central bank in a high-debt country because the central bank obviously can't bankrupt the government. That's not a constraint in the EMs. 

The portfolio is weighted towards BBB and BB-rated bonds. Why are you finding more opportunities in these areas?

First, investment grade (IG) dollar-denominated bonds have very low spreads right now, and they are effectively a Treasury proxy trade. I don't think I'm the world's leading expert in Treasuries, and I don't think investors give me money to invest in EM based on my opinion on Treasury. IG and dollars are not attractive. 

We find some attractive names in corporates and below investment-grade in dollars, but sovereigns are still very cheap, spreads are very high and these are the countries that are actually winning. Some of these are Latin-American but a lot of Sub-Saharan African names with low ratings, a bad image but great fundamentals based on our process. They are paying us a lot. They are benefiting from the news in the world. A lot of these countries, Nigeria for example, have arguably the best politics in 30 years. The standard isn't great, but there have been dramatic improvements.

Second, the other key point is that for local currency bonds, the rating is only on repayment risk. In other words, the rating agency only rates the country's ability to repay the bond in their own currency. Those ratings, by definition, are going to be higher. The idea that low rating means low volatility for local is not always the case. You do need to process and think about things on a country-by-country basis. But there too, the lower-rated bonds pay you a lot more.

Which regions are you most bullish on?

Sub-Saharan Africa and Latin America.

If I were going to keep it simple, Sub-Saharan Africa is replacing Russia as the commodity supplier to Europe and a lot of them have really positive policy developments. You could say Zambia, Angola and you could definitely say Nigeria. The Ivory Coast has been an anchor of stability in the region. There are a lot of really good stories because of the unfounded image. They are cheap and it's my job to take advantage of it.

The other area is Latin America - commodities exporters and generally healthy political environments. I know Brazil has the image of volatile politics but the one thing that characterises most Latin countries, and even a lot of the Sub-Saharan African countries is voters themselves get it. It's very hard to find, for example in Mexico, left-wing voters that will succumb to an argument to use the central bank to generate economic outcomes. The reason is they've tried it and it failed and it blew up. The banks kill the poor and kill governments and there's a really deep understanding to spend how you want. You want to spend on social, reduced defence, not my business. As long as you meet your budget and that's what a lot of them are doing.

What three key rules should investors keep in mind when investing in this space?

1. The alpha space is in the EM not in the DM. If you think you're going to do well in DM, good luck, I don't see it.
2. When you look at EM, don't look at it like a blob. It's not homogeneous. Do it country by country.
3. Don't be afraid to think for yourself. If it makes sense, let it make sense. The biggest obstacle we have when we sit across from investors is not them - they all agree. The biggest challenge is explaining it to their end investors that these countries haven't generated problems in 20 years, they've generated much greater returns. We work with investors not to convince them - they are convinced - we help them convince their end investors that this is the right thing to do.