Kroum Sourov
Portfolio Manager, Emerging Market Debt
The speed at which emerging countries have developed since the 1980s has fuelled fast-paced growth in their debt markets. Emerging market external sovereign debt provides access to more than 80 countries with outstanding debt in excess of $1.6trn[1]. External debt should present a limited currency risk as it encompasses government debt denominated in hard currency, mainly US Dollars and Euros. Nowadays, these markets may offer attractive yields and diversification benefits closer to US and European rates and credit markets.
Candriam defines our sustainable universe using our proprietary sustainable sovereign analysis, which is built on four pillars. These four are the Natural Capital, Human Capital, Social Capital and Economic Capital. We calculate a score for each pillar of each country, based on more than 400 individual time series[2], and adjusted to reflect the materiality of each type of data series.
Our methodology differs by emphasising Natural Capital, using it as a multiplier of the other pillars. We do this to incorporate the significant and often irreversible cost to Natural Capital when it is used to enhance the other types of capital. Multiplying the Natural Capital score times the average of the other three pillar scores generates an overall ESG score, and we exclude the issuers that score below the 25th percentile. Further, we exclude countries which fall short of norms-based standards, including those on the FATF (Financial Action Task Force) "Call to Action" list, those on the Freedom House "Not Free" list, or those on the Candriam Oppressive Regime List. We may also apply discretionary exclusion when our analysis and engagement efforts offer us the conviction that this is necessary. Furthermore, we exclude all issuers that are rated below B- by one of the three major rating agencies[3].
As a result of these analyses, the investable universe of the strategy offers a superior sustainability profile and we believe it to consist of the group of countries with greatest chances to prosper in the economy of the future. Our strategy aims to support these countries on their development path and to also offer exposure to the most promising set of opportunities in the economic transition. However, the method does imply certain biases. Firstly, the strategy has a higher quality bias since it cannot include issuers rated CCC+ and below. Furthermore, the strategy has a structural underweight of energy exporters as they typically have lower scores in our sovereign sustainability model (weaker Natural capitals). Finally, from a regional perspective, the strategy has no exposure to the Middle East and consequently a higher allocation to Latin America and Eastern European regions.
We had identified three sustainable KPIs that we believe are pivotal to Emerging Markets issuers, which we apply to the strategy. The strategy aims to achieve an overall ESG Score above its benchmark (JPM EMBI GD Index), seek a CO2 intensity that is less than 70% of the benchmark, and maintain minimum standards of democracy (which we measure through the Freedom house score).
The KPIs are monitored daily not only by the investment team, but also by our independent risk management team. We also monitor indicators such as the Paris Equity Check, the Democracy Index and the Corruption Perception Index, though we do not set limits on these elements.
The emerging debt asset class has benefited from improvements in economic stability, institutional strength and political decision-making in these countries. Over the past 40 years, emerging market debt has developed at a spectacular pace, and today offers a wide variety of opportunities for investors to capitalize on: government bonds (denominated in USD, EUR, or local currency), corporate debt and emerging markets currencies. As a result of these changes, emerging debt evolved from a niche to a major asset class by the late 1990s.
Since our primary aim is to generate risk-adjusted returns, we continuously analyse the risks associated with this asset class.
Investing in emerging market debt presents a number of important risks that need to be carefully considered. First and foremost, US interest rate policy has a strong impact on these markets. Higher US interest rates translate into higher borrowing costs for emerging countries, which can impact their ability to repay their debt.
The volatility of the US dollar is also a major concern. A stronger dollar can increase the burden of dollar-denominated debt for these countries, as their tax revenues remain in local currency.
Raw materials are also key. Many emerging nations are heavily dependent on exports. Fluctuations in commodity prices can affect the fiscal health or the foreign exchange reserves of these countries and, consequently, their funding costs and ability to meet their debt obligations.
China's influence should not be underestimated. As a major trading partner for many emerging countries, changes in China's economic policies or trade relations can have far-reaching consequences, affecting both the economic stability of other emerging nations and the attractiveness of their bonds to investors.
As a result, a comprehensive understanding of these risks is essential to making informed investment decisions in emerging market debt.
Our emerging markets debt investment process include a bottom-up analysis to assess the issuers and an analysis of the security based on the relative value. Relative value plays a pivotal role in our investment process as it allows us to pinpoint the right security across various countries and/or companies, aligning with our investment convictions. By measuring relative value through an analytical and disciplined approach to valuations, we are able to identify the bonds which, in terms of risk/return profile, best reflect our views. Then, we are able to build a portfolio enhancing the opportunities and managing the risks emanating from the debt of emerging markets.
For example, once a conviction has been identified through our fundamental analysis, this conviction can be incorporated into the strategy through different types of bond instruments, such as sovereign, quasi-sovereign, corporate, long-term or short-term debt, denominated in US Dollars or Euros. This analytical approach empowers us to align our investment choices with our investment objective.
We identify relative value opportunities in securities issued by sovereign, quasi-sovereign and corporate issuers, based on three levels of analysis.
Firstly, we carry out a quantitative analysis, particularly through our sovereign risk modelling framework, to assess the creditworthiness of each country. This analysis standardizes risk assessment across all Emerging Markets, based on an analysis of macroeconomic and ESG trends.
The analysis of issuers' creditworthiness forms the foundation of our approach which drives value creation.
Subsequently, we complement the quantitative analysis with a qualitative review of the macroeconomic and structural reform, political risk trends to which emerging sovereign issuers are exposed. This qualitative review, drawing from both external sources and internal research, serves to capture nuanced performance drivers and political risks, enhancing our Sovereign Risk Model insights.
We integrate the results of the quantitative Sovereign Risk Model with our qualitative assessment to arrive at our final portfolio positions.
In addition, the team examines relative valuations of instruments, typically with comparable risk categories. On the instrument side, relative value opportunities tend to cover several dimensions: type of security, cross-analysis of currencies, maturities.
Our methodology was developed – and is continuously being improved – to meet our objective of generating risk-adjusted performance. Our approach aims to identify investment opportunities through an analysis of issuing countries and instruments, while controlling risk.
This approach largely explains our track record in a wide variety of market configurations since the strategy's inception in 1996.
Our team draws on a comprehensive set of analytical tools, developed in-house, to identify investment opportunities. Our process is based on rigorous fundamental analysis and relative value assessments. It incorporates ESG (Environment, Social & Governance) factors, which are essential for us to judge the creditworthiness and long-term development potential of countries and companies.
We pay close attention to risk, not only when choosing what to invest, but also during the implementation phase. Our internal investment limits, together with an analysis of the overall market environment, guide us in building the portfolio. We only include those risks that we consider worth taking.
Finally, we have a dedicated investment team and a flexible, collaborative decision-making process. Our team's experience in emerging markets is reinforced by complementary product and regional expertise.
Kroum Sourov and Christopher Mey, portfolio managers of the sustainable emerging market debt strategy, describe the significance this type of analysis can have for a bond portfolio. They explain Candriam’s investment process, with our emphasis on relative value and risk management. This approach is intended to allow the strategy to adapt the ever-changing markets over the course of an economic cycle.
The risks listed are not exhaustive, and further details on risks are available in regulatory documents.
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Warning: Past performance of a given financial instrument or index or an investment service or strategy, or simulations of past performance, or forecasts of future performance does not predict future returns. Gross performances may be impacted by commissions, fees and other expenses. Performances expressed in a currency other than that of the investor’s country of residence are subject to exchange rate fluctuations, with a negative or positive impact on gains. If the present document refers to a specific tax treatment, such information depends on the individual situation of each investor and may change. In respect to money market funds, please be aware that an investment in a fund is different from an investment in deposits and that the investment’s principal is capable of fluctuation. The fund does not rely on external support for guaranteeing its liquidity or stabilizing its NAV per unit or share. The risk of loss of the principal is borne by the investor.
Information on sustainability-related aspects: the information on sustainability-related aspects contained in this communication are available on Candriam webpage https://www.candriam.com/en/priofessional/sfdr/.
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