While emerging market debt might have been considered volatile some years ago, increased participation in the market by local investors and proactive central bank measures have led to lower volatility, according to Hermes Investment Management’s Nachu Chockalingam.
Chockalingam – a senior emerging market debt portfolio manager who oversees the emerging market sleeve on the $451.3m Hermes Unconstrained Credit fund – said the market has become less volatile than in previous years.
“To be sure, emerging markets are still considered more volatile than developed markets, and naturally that’s going to be the case,” Chockalingam conceded. “But there’s little doubt that volatility appears to have subsided.”
As the below chart shows, rolling three-month volatility of the JPM GBI-EM Global Composite index – a commonly used, US dollar emerging market debt benchmark tracking local currency emerging market bonds – has dropped over the past 12 months.
Rolling 3mth volatility of JPM GBI-EM Global Composite over 1yr
Source: FE Analytics
Indeed, there has been a more proactive approach by emerging market authorities to protect their economies during challenging periods, helping to limit the potential spread of contagion to other areas.
“We have seen a lot of action this year in a lot of countries,” she said, citing stimulative measures by the Chinese government—stepped up fiscal expenditure, larger cuts in taxes and fees—as the tariff war with the US takes a toll on the Asian giant’s trade sector.
While the US-China trade war has once again become a challenge to markets, said the manager, it should not be considered an emerging markets issue, but a global one.
In addition, the portfolio manager stressed that financial crises no longer spread throughout emerging economies as they used to.
“What we have increasingly noticed, at least in the past five years, is that contagion has become much more limited,” she said.
She highlighted various crises across the emerging market space last year, including the Argentina IMF crisis and the Turkey crisis.
“Now, if you look at each of those crises, you find they did not spread beyond those countries’ borders,” she said, noting that for example Turkey crisis clearly impacted Turkey’s spreads, but it did not affect spreads in other economies.
In addition, there are signs that the market is becoming more sophisticated with more local investors having a greater understanding of issues on the ground participating in it. 
“So, we find that crises in the emerging markets have become much more contained,” said Chockalingam (pictured). “The reason is that domestic investors are growing [in number], so you have a lot more support from local investors. You have more sophisticated local investors who are better able to isolate issues.”
While central banks have become more proactive in managing economic challenges, there is still political volatility to contend with, she said, although elections have passed off with few problems more recently
“These political events create noise, which could mean more volatility. With less noise, we might expect less volatility,” she said, “Macro-wise, things are now fairly subdued politically.”
Emerging markets are also global growth leaders, as developed economies continue to grow slowly, with post-financial crisis measures remaining in place.
“According to recent IMF data, these economies are expected to grow this year by north of 4 per cent on average,” she said.
Source: International Monetary Fund
This growth is driven by domestic economic growth, she pointed out: “But as capital markets in these countries develop, their need for capital increase accordingly and they look for different sources of capital.”
She said domestic financial markets in these countries may not be very deep, “and they don’t have a lot of opportunities or money for investment or capital expansion, and so on,” she added. “And that’s why they go offshore.”
As such, Chockalingam said, emerging markets are becoming larger, more liquid and more sophisticated than the broader market has yet appreciated: emerging market credit is now $1.5ttn in terms of size; 8.5x larger than it was back in 2005.
And it’s not just in sovereigns that the outlook is positive, said the portfolio manager, highlighting the strength of emerging market corporates relative to their developed market peers.
Nevertheless, the Hermes manager said a large emerging market premium still exists in terms of credit spreads, and “although a certain premium is still necessary, we believe it will narrow as investor sophistication grows and the asset converges more to the mainstream”.
On allocation, Chockalingam said her team aims to be nimble and flexible but also run concentrated portfolios consisting of the best opportunities in the market.
“When we find a country, we then look across its different sectors to find the companies that we think are going to offer the best returns,” she said.
For example, last year, they looked for exporters and within that space and at countries like Brazil and Chile, assessing their potential for returns.
“Right now, we’re touching the government-owned companies and the very large corporations within those markets,” Chockalingam said.
The team also keeps an eye on medium-size companies. “As these become more scalable, they’ll look to source funding offshore,” she said.
She pointed out that a lot of investors, given where rates have been for many years, seek asset classes that offer slightly higher yields.
“So, investors’ focus is shifting towards these businesses and that’s creating a lot of opportunities for emerging market companies versus developed market companies.”
A key focus of the manager is the credit rating of a company, which is not allowed to “pierce the country ceiling” or have a higher rating than its home country’s sovereign rating.
And because the rating is lower, you often find that your spread from buying an emerging company is higher than the one you get from buying a developed market company, she said.
“Comparing a developed market company and an emerging market company, if the fundamentals are similar, or even slightly better in the developed market, you often find you get paid more buying the emerging market,” the manager added.
Nevertheless, for investors interested in emerging markets, the portfolio manager stresses due diligence.
“Be selective and don’t try to buy everything you find in a particular market,” she concluded. “Try to buy the best quality you can for the valuation.”
The Hermes Unconstrained Credit fund has been managed since launch in 2018 by Andrew Jackson and Fraser Lundie targeting capital growth and a high level of income over the long term.
It has a 9.83 per cent exposure to Latin America, 3.89 per cent in eastern Europe, 237 per cent in Middle East & Africa and 1.55 per cent in Asia emerging markets.
Performance of fund vs sector since launch
Source: FE Analytics
Since launch, it has made a total return of 20.06 per cent against 11.28 per cent for the average IA Global Bonds peer. It has an ongoing cost figure of 0.78 per cent.