From Setback to Opportunity

By Eric Fine
Head of Active EM Debt

The VanEck Emerging Markets Bond Fund (EMBAX) utilizes a flexible approach to emerging markets debt investing and invests in debt securities issued by governments, quasi-government entities or corporations in emerging markets countries. These securities may be denominated in any currency, including those of emerging markets. By investing in emerging markets debt securities, the Fund offers exposure to emerging markets fundamentals, historically characterized by lower debts and deficits, higher growth rates and independent central banks.¹ The expanded PDF version of this commentary can be downloaded here.

Market Review

The Fund was down -0.06% in October based on net asset value outperforming its benchmark, which was down -0.65%. YTD, the Fund outperformed its benchmark by 1.76%; the Fund was down -2.74%, compared to its benchmark, which was down -4.50%.

^†Monthly returns are not annualized.

Expenses: Class A: Gross 2.30%; Net 1.25%. Expenses are capped contractually until 05/01/22 at 1.25% for Class A. Caps exclude acquired fund fees and expenses, interest expense, trading expenses, dividends and interest payments on securities sold short, taxes and extraordinary expenses. Please note that, generally, unconstrained bond funds may have higher fees than core bond funds due to the specialized nature of their strategies.

The tables above present past performance which is no guarantee of future results and which may be lower or higher than current performance. Returns reflect temporary contractual fee waivers and/or expense reimbursements. Had the Fund incurred all expenses and fees, investment returns would have been reduced. Investment returns and Fund share values will fluctuate so that investors’ shares, when redeemed, may be worth more or less than their original cost. Fund returns assume that dividends and capital gains distributions have been reinvested in the Fund at Net Asset Value (NAV). An index’s performance is not illustrative of the Fund’s performance. Certain indices may take into account withholding taxes. Index returns assume that dividends of the index constituents in the index have been reinvested. Investing involves risk, including loss of principal; please see disclaimers on next page. Please call 800.826.2333 or visit vaneck.com for performance current to the most recent month ended.

Our low exposure to J.P. Morgan Emerging Market Currency Index (“EMFX”) helped the Fund in October, and we expect EMFX to remain under pressure. Our exposure to some higher-risk USD-denominated bonds that had hurt the Fund in September rebounded, boosting performance as well. We think this is noteworthy because our re-positioning for a different risk context seems to have worked. We are notably more defensive on Emerging Markets (“EM”) debt, with roughly 70% of the Fund in hard currency, duration of 6.7, and carry² of 5.2%. We continue to favor Mexico, Brazil, South Africa and now Peru and UAE are among our top exposures.

We are less concerned about the setback we warned about in our September monthly (“Setup for Setback”), for four reasons (enumerated below), but largely because the setbacks we were concerned about have happened and we had adjusted the portfolio in anticipation.

As a result, we are now more focused on the opportunities, not the risks. Our basic adjustments after “Setback” were to significantly reduce high-beta EMFX, and to increase USD-denominated bonds. In September we market-performed – despite this anticipatory positioning – but as we noted, having low EMFX still helped performance a lot, and it was the riskier USD bonds that were hit by the general risk-off that kept us performing only in-line with the market that difficult September. As we said last month, we think the USD bonds selloff would be temporary, whereas the EMFX selloff would not. Now that some dust is settling, October seems to show clearly that EMFX is still struggling while EM USD bonds are rebounding (see below), so our conviction on our changes has increased.

Why less worried about a setback?

First, stagflation³ is a very popular concern by now (it used to be a key fear of ours), and we may at least see positivity on growth. EM growth shortfalls have been largely due to Covid, while vaccination rates are up, as presumably is natural immunity. Second, the USD has rallied; we expect more and see it as confirming (not ending) our view, but that simply means avoiding high-beta EMFX, not avoiding EM USD debt, which we’ve already done. Third, the “where else do you go for yield other than HY and EM” story is intact, especially in USD-denominated bonds, which is where we shifted as part of our “Setback” view. Look at Exhibit 1 below, where if you want spread in Investment Grade (“IG”) or High Yield (“HY”), EM (corporate and sovereign) pays more. Local currency pays high-ish nominal yields, too, but they do not pay the usual premium they do over USD-denominated bonds. Fourth, almost everything we wrote about in “Evergrande is Spreading” has happened, and we are now actually seeing selective opportunities in that space. Exhibit 2 is an update on the bonds we’ve been tracking since we wrote that piece. Our worry was that the whole property sector needed to be repriced, and now it has. We could obviously be wrong, but our point is that it is much harder to be bearish at prices in their 20s than at prices near par, where they were when we were initially concerned.

Exhibit 1 – EM Debt, Especially HY, Still Looks Like the Belle of the Ball (Just not Local-Currency EM)

Yield to Maturity

Source: VanEck, Bloomberg; data as of August 31, 2021. Past performance is not a guarantee of future results.

Exhibit 2 – Harder to Be Worried About China Property With Much of Sector Already Re-Priced

Evergrande vs Peers – Bond Price

Source: Bloomberg; data as of November 8, 2021. Not intended as a recommendation to buy or to sell any of the securities mentioned herein. Holdings will vary for the Funds and their corresponding Indices. Past performance is not a guarantee of future results.

And, even though we are averse to EM local currency currently, EM policymakers are doing their usual great job of making their interest rates more attractive.

The chart below shows some EM policy rates versus some DM policy rates. EMs keep hiking. Their central banks view their jobs as primarily fighting inflation and inflation expectations. There’s more to go, thus our caution. They allowed their currencies the flexibility to weaken, thus our caution. But, make no mistake, it is good policy. And, it has practical implications. For over a decade now, EM has basically not had USD shortages. There are many reasons behind this, and we’ve written about them. But the bottom line is that high real interest rates keep EM external accounts strong. This means that while we remain concerned about their local-currency bonds, we are not (generally speaking) worried about their USD-denominated bonds. Look at Exhibit 3 and tell us which countries’ central banks are confidence-inspiring.

Exhibit 3 – EM Policy Rates High and Rising

Real Policy Rates in EM and DM (%) 12m from now if current expectations for rates and inflation were to materialize

Source: VanEck; Bloomberg. Data as of November 8, 2021.

There remain plenty of attractive – albeit more uncorrelated or defensive – EM bonds.

Zambia is moving towards an IMF agreement, Ecuador’s policy (and IMF agreement) continue to bear fruit, Peru’s new government is becoming even more market-friendly, El Salvador’s bonds are cheap enough to reflect near-term risks and they’ve received a boost from their Bitcoin strategy, etc. Also, one of our longstanding points is that many EM countries have plenty of dollar assets relative to dollar liabilities, so the dollar bonds of a number of countries that might have other problems, remain very defensive in our opinion (the song would be titled ‘ninety-nine problems but dollars ain’t one’). Brazil, Chile, Colombia, South Africa and others are among these.

A comment on U.S. yields.

Greater political concerns in the U.S. over inflation, combined with new challenges to U.S. spending, translate into risks of a flatter U.S. yield curve, in our view. Risks on the U.S. Federal Reserve (Fed) policy side seem on the more hawkish side, to us. While a lower fiscal impulse from political setbacks for the Democrats (along with a China that is less growth-obsessed) should mean long-end rates rise less. Bottom-lines: bullish for USD, OK for risk and be open-minded (not outright bearish) on duration.

EXPOSURE TYPES AND SIGNIFICANT CHANGES

The changes to our top positions are summarized below.

• Our largest positions in October: Mexico, Brazil, China, Peru, and United Arab Emirates. We increased our hard currency exposure in Brazil, Colombia and Dominican Republic, and hard currency quasi-sovereign exposure in Colombia. Despite multiple concerns about Brazil’s fiscal trajectory, the country’s external metrics (international reserves, basic balance) remains very strong, and it will only continue to benefit (adjust) from the weaker currency, improving the economic test score for the country. Dominican Republic suffered a setback on the tax reform front, but growth, fiscal performance and inflows are getting a major boost from the revival of tourism and very high overseas remittances, all of which improved the economic text score for the country. We added Colombia exposure after the rating outlook upgrade and encouraging IMF meetings which show the government’s coherence, elements of orthodox policy framework (managing to pass a tax reform) and the stronger recovery. In terms of our investment process, this improved the economic and policy test scores for the country.
• We also increased our hard currency corporate exposure in China and Tanzania. Corporate bonds in China were issued by battered real estate developers. Their prospects improved after authorities blinked and eased some mortgage regulations for large banks until the end of the year, and after some developers paid their coupons. In addition, the central bank told developers to honor their debt obligations, stopping (at least for now) the vicious circle. In terms of our investment process, the policy test score for the country was no longer deteriorating, while the technical test score for companies in question improved a lot. A Tanzanian corporate bond was a new issue. The company is also Investment Grade with very decent valuation (the initial allocation bucket #2).
• Finally, we increased our hard currency sovereign exposure in Sri Lanka, El Salvador and Bahrain. During this year’s Annual IMF Meetings, Sri Lankan authorities showed their determination to meet debt obligations, lining up alternative types of capital inflows (not market-access) and boosting the policy test score for the country in the process. El Salvador’s valuations remain very attractive – translating into a positive technical test score – albeit we are aware that (a) some assumptions behind the 2022 budget are optimistic, and (b) balancing it would require a very determined effort to keep spending under control. In Bahrain, bond are supported by higher oil prices, which make valuations more attractive.
• We reduced our local currency exposure in Mexico, taking partial profits on the position that performed well this year.
• We also reduced hard currency corporate exposure in Ghana and Nigeria. In Ghana, this year’s Annual IMF Meetings showed no sense of urgency on the fiscal front. Structural reforms are struggling, and the government’s strategy continues to depend too much on getting market access. In Nigeria, higher oil prices are not boosting growth or improving fiscal performance, adding to overall policy concerns (including the exchange rate). In terms of our investment process, these developments worsened the company test score for the bonds in question.
• Finally, we also reduced hard currency sovereign exposure in Turkey and Gabon. Turkey’s policy framework continues to deteriorate. President Recep Erdogan’s decision to fire more members of the central bank’s monetary policy council forced the latter to deliver a larger than expected policy rate cut, which increased pressure on the currency. For now, we see little evidence of currency interventions, but there is a risk that they will return, in which case Turkey’s sovereign bonds will suffer. All this means, that Turkey’s policy test score continues to deteriorate.

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Originally published by VanEck on November 19, 2021.

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