Commentary by Nick Eisinger, emerging markets lead strategist, Vanguard Europe.

 

  • Since the inception of the Vanguard Emerging Markets Bond Fund three years ago, our approach has remained consistent throughout and has enabled us to generate alpha1.
  • This consistent approach has enabled the fund to successfully navigate major challenges for the asset class, including Covid-19, the Russia-Ukraine war and rising US interest rates.
  • We are confident that our fundamentals-led approach will allow us to continue to identify relative-value opportunities as further unforeseen challenges in emerging markets arise.

 

The expression ‘may you live in interesting times’ feels extremely pertinent for investors in emerging market (EM) debt. But as the Vanguard Emerging Markets Bond Fund celebrates its third anniversary, the fund’s first three years of existence have demonstrated that it is possible to generate alpha1 in the asset class - provided you take an approach focused on risk management and the avoidance of correlated, concentrated risk factors.

Events such as the Covid-19 pandemic, Russia’s invasion of Ukraine, the end of easy money and a strengthening US dollar have all posed difficulties for all EM bond funds. However, they have equally presented opportunities for us to leverage and benefit from our active investment approach that centres on factors including security selection and relative value.

Managing through a global shock

Covid-19 prompted widespread government action that caused a sudden deterioration in global sovereign balance sheets. It also caused a sharp decline in fiscal revenues as a result of pandemic-induced restrictions that vastly reduced economic activity levels. Meanwhile, economic stimulus programmes and higher healthcare costs meant that government spending rapidly increased. Indeed, Covid-19 support packages implemented across EM economies in the early part of the pandemic averaged 3% of GDP2.

Since the economic fundamentals of EM sovereign-debt issuers varied wildly at the outset of the pandemic, it was crucial for our active fixed income team to accurately evaluate and anticipate differences in credit fundamentals. Vanguard’s EM credit team continually assesses issuer fundamentals and where they may be heading, which allowed the fund to enter the most attractive risk-adjusted trades during an incredibly uncertain period for bond markets.

Our focus during the pandemic was on medium-quality debt, rather than very high- or very low-quality bonds. This offered adequate protection from a turbulent period for the world economy while providing scope for issuer fundamentals to improve as the macroeconomic outlook ultimately recovered.

Dealing with war in Europe

Russia’s invasion of Ukraine presented a new dimension of risk for EM fixed income markets. It led to heightened market volatility and economic costs such as rising energy prices. Ukrainian sovereign bonds were hit hard, and Russian assets experienced a vast sell-off in response to significant sanctions placed on the country.

Our focus on relative value allowed us to identify EM bonds that traded at favourable valuations in this ‘risk-on’ environment. However, we remained mindful of the potential threat from ‘crowded’ trades, including those in Ukrainian sovereign debt. We were also careful to avoid making excessive directional bets that could have increased risk in what was a highly uncertain and volatile environment.

The Ukraine war highlighted the importance of trade sizing in EM fixed income markets. Tail risks carry significant downside implications that are limited by our fund’s strict approach to position sizing. We also remain alert to the risk of contagion to the wider region amid elevated geopolitical and economic turbulence.

Navigating the end of easy money

EMs have also faced challenges associated with a rapid tightening of monetary policy by the US Federal Reserve (Fed). Historically, rising interest rates in the developed world have led to lower EM investment flows as investors sell non-US dollar-denominated assets in favour of higher-yielding US dollar-denominated assets. In addition, a less accommodative monetary policy across the developed world is unlikely to be conducive to a higher rate of global economic growth. This may result in pronounced financial challenges for EMs.

Indeed, a worsening economic outlook has prompted several EM countries to enter debt-restructuring negotiations. Others have the potential to follow suit, with their bonds behaving as if they were distressed.

While we adopt a cautious stance when it comes to distressed debt, it presents significant opportunities to generate alpha. Even if some sovereigns ultimately undergo debt restructuring, their restructured bonds are in many cases likely to be worth more than the distressed price at which they were purchased. Our focus on relative value helps us to judge the optimum price at which to buy distressed issues and capitalise on their return potential.

Staying focused while the dollar strengthened

The Fed’s rate rises led to a strengthening of the US dollar during much of 2022, causing increasing challenges for EMs. In many cases, EMs were already struggling to manage their fiscal deficits after implementing major stimulus action in response to Covid-19. A stronger greenback has made it harder and more expensive for them to not only service and pay down existing debt, but to raise commercial funding.

Our approach to a stronger US dollar is to remain focused on security selection through a robust process that thoroughly assesses sovereign credit quality. Trading size and liquidity are also key aspects of our strategy, allowing us to avoid concentrated positions and reduce overall risk. And, as with any period of uncertainty facing EMs, our bottom-up focus allows us to seek out relative-value opportunities.

A consistent approach throughout

The Vanguard Emerging Markets Bond Fund’s first three years have shown that it is possible for active investors to effectively chart a course through eventful and volatile times in EMs1. Although the Covid-19 pandemic, Russia’s invasion of Ukraine, the end of easy money and a stronger US dollar are in some respects very different risk events, they have all led to heightened levels of volatility and uncertainty. And that’s before you consider the host of other idiosyncratic risk events that have beset EMs during that time.

Being prepared for further uncertainties

Undoubtedly, other unforeseen events that prompt sell-offs, debt restructurings and high levels of volatility across EM bonds will occur in the future. Predicting them ahead of time is not always possible. Therefore, we intend to rely on the same core principles that have enabled us to overcome—and take advantage of—the range of events that have taken place in the fund’s first three years of existence.

This provides us with optimism about the future for the fund while we remain constantly alert to potential threats and opportunities that, as the past three years have shown, can occur at any time and without warning.

Written in collaboration with Cong Lu, senior investment risk manager, Vanguard.

 

The Vanguard Emerging Markets Bond Fund seeks to provide total return while generating a moderate level of income by investing primarily in bonds of issuers in emerging market countries. The management team has the advantage of integration in Vanguard’s large, experienced, multi-sector Fixed Income Group. The group has over 35 years' experience running active strategies and includes experts on economics, interest rates, industry sectors, risk, trading and security analysis.

Our active bond funds managed in-house

Vanguard Emerging Markets Bond Fund

Vanguard Global Credit Bond Fund

 

Rolling performance (as at 30 November 2022)

Year on year return (%)

4 Dec 2017 –
3 Dec 2018

4 Dec 2018 –
3 Dec 2019

4 Dec 2019 –
3 Dec 2020

4 Dec 2020 –
3 Dec 2021

4 Dec 2021 –
3 Dec 2022

Vanguard Emerging Mkts Bd Inv EUR H Acc

15.86

-1.19

-14.04

JPM EMBI Global Diversified Hedge TR EUR

4.42

-1.94

-18.82

Vanguard Emerging Mkts Bd Inv GBP H Acc

16.54

-0.45

-13.12

JPM EMBI Global Diversified Hedge TR GBP

4.8

-1.2

-17.9

Vanguard Emerging Mkts Bd Inv USD Acc

18.07

-0.1

-11.53

JPM EMBI Global Diversified TR USD

6.33

-0.89

-16.53

Past performance is not a reliable indicator of future results.
Source: Vanguard and Morningstar, as at 30 November 2022. Performance figures include the reinvestment of all income and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV. Basis of index performance is total return. All performance is calculated in GBP, net of fees, and the return may increase or decrease as a result of currency fluctuations.

 

1 Source: J.P. Morgan and Vanguard, as at 30 November 2022. Since its inception on 3 December 2019, the Vanguard Emerging Markets Bond Fund has outperformed its index, the J.P. Morgan EMBI Global Diversified Index, by a cumulative 16.4%. Past performance is not a reliable indicator of future results.

2 Source: IMF Fiscal Monitor, October 2020.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

The Vanguard Emerging Markets Bond Fund may use derivatives, including for investment purposes, in order to reduce risk or cost and/or generate extra income or growth. For all other funds they will be used to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Funds net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.

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