Stockholm (HedgeNordic) – Institutional investors are continually engaged in the pursuit of investment portfolio diversification. Their investments span a wide range of asset classes, ranging from risk-free government bonds to riskier equity investments. While the majority of investments within the middle range of this risk-return spectrum typically involve exposure to corporates, emerging market sovereign debt, positioned within this same spectrum, presents itself as an opportunity for portfolio diversification.
“The diversification benefit is really important, particularly within the local currency market where correlations with traditional asset classes are low, and even more so within frontier local currency markets,” explains Henrik Paldynski, the Head of Emerging Markets Debt at Aktia Asset Management. “While there is some correlation between high-yield bonds and emerging market hard currency bonds, for instance, the underlying assets are fundamentally different. That’s where the diversification comes from,” emphasizes Paldynski.
“The diversification benefit is really important, particularly within the local currency market where correlations with traditional asset classes are low, and even more so within frontier local currency markets.”
Even more importantly, the emerging markets debt universe is notably more heterogeneous than one might initially perceive. “Partly due to historical categorization, everything that is not developed markets – anything outside Europe, North America or Japan, mysteriously falls under the umbrella of emerging markets, even if such classification may not necessarily be accurate,” points out Paldynski. Interestingly, Lebanon and Zambia, both of which defaulted on their debt, find themselves in the same group as Abu Dhabi and Qatar. “This illustrates that vastly different types of investments coexist within the emerging market debt space,” notes Paldynski. “You have segments within emerging market debt that are virtually risk-free, alongside distressed high-yield. The level of variation is huge.”
Hard versus Local Currency Debt
While there are various approaches to categorizing the emerging market debt asset class, the most important differentiation lies between local currency debt issued in the sovereign’s domestic currency and hard currency debt, primarily issued in U.S. dollars or other hard currency. Although both types of debt are government bonds, they possess different structural characteristics.
“Hard currency debt is essentially a spread product comprising U.S. treasuries plus a risk premium,” notes Paldynski, who leads a team of nine experts specializing in investments in local and hard currency sovereign debt across emerging and frontier markets. “U.S. interest rates will automatically have an impact on the pricing and risk premium, similar to corporate credits,” he explains. The credit spread reflects the sovereign default risk. “Therefore, the main return driver is the indebtedness of the country and fiscal consideration.”
“Hard currency debt is essentially a spread product comprising U.S. treasuries plus a risk premium.”
A local currency debt investment, on the other hand, is “a rates product with a credit risk component rather than a spread product,” according to Paldynski. “In local currency debt investments, you have more return drivers such as local inflation, monetary policy, and exchange rates,” he elaborates. “This diversification is advantageous since it’s not the same Jerome Powell driving every other asset class.”
“In local currency debt investments, you have more return drivers such as local inflation, monetary policy, and exchange rates.”
Although this segment of the emerging market debt universe offers the highest yields, these bonds also tend to exhibit the highest volatility due to fluctuations in foreign exchange rates. With a multitude of factors and variables influencing currency movements, expertise in each country’s economic landscape becomes paramount. Consequently, for the seasoned investor, local currency bonds offer a more dynamic investment opportunity compared to hard currency bonds.
Team Effort Across Three Different Strategies
Aktia Asset Management operates three distinct strategies focusing on emerging market debt: one centered on hard currency debt, another on emerging markets local currency, and the third on frontier local currency debt. While each strategy has responsible portfolio managers, Henrik Paldynski, as the Head of Aktia’s Emerging Markets Debt team, underscores the collaborative nature of investing in these markets. “This is a team effort and information sharing and cooperation are super important.”
“This is a team effort and information sharing and cooperation are super important.”
Aktia Asset Management, which oversees €2.1 billion in investments across the three strategies, has deliberately cultivated specialized expertise by concentrating on sovereign emerging markets bonds. “We completely disregard corporates and other issuers in emerging markets. Our focus is solely on FX and sovereign risk,” says Paldynski. Another tenet of the asset manager’s philosophy is skepticism toward indices as a suitable basis for portfolio construction, particularly in emerging markets. “While we may not outperform the benchmark every year, we firmly believe that our approach of disregarding the benchmark or being benchmark-agnostic will yield superior results in the long term.”
Yet another core pillar of Aktia’s investment philosophy regarding emerging market debt is skepticism toward short-term trading as a means of creating significant additional value for investors. “The local traders, the local banks will always have an information advantage,” notes Paldynski. “Therefore, our focus lies in selecting the countries where we want to be invested and we tend to stay invested in those countries for a long time.”
Country Selection
Aktia’s investment process starts with country selection. “We want to avoid countries where we detect deteriorating fundamentals,” begins Paldynski. To achieve this, the team evaluates a universe of over 100 countries using a signaling and monitoring model based on 48 indicators. “We look at both short and long-term changes that signal shifts in a country’s conditions,” he elaborates. This approach forms the backbone of Aktia’s Traffic Light Approach, which guides discussions on whether a country is non-investable, partially investable (no government financing) and fully investable.
“While the economics have a strong explanatory strength in the short term, it’s important to look into the factors that underpin that strong economic growth in the medium term and those are the governance questions.”
Paldynski emphasizes the importance of considering factors beyond a country’s economics when investing in emerging markets over the long term. “While the economics have a strong explanatory strength in the short term,” explains Paldynski, “it’s important to look into the factors that underpin that strong economic growth in the medium term and those are the governance questions.” In the long term, “the social questions become important, as weak social structures hinder both governance and economic improvements.” Therefore, Aktia integrates Environmental, Social, and Governance (ESG) factors into its investment process, recognizing that focusing on governance, social, and environmental factors across different time frames is essential for long-term investment success in this universe.
“The social questions become important, as weak social structures hinder both governance and economic improvements.”
“That is where the qualitative part of the process comes,” continues Paldynski. This process involves reading, researching, staying updated with the news, and extensive traveling. “We’ve conducted more than 150 face-to-face meetings with government authorities, finance ministries, and central banks only in 2023,” he elaborates. These interactions serve as the foundation for discussions and decisions regarding country selection. “These are not supposed to be quick changes. We are looking at fundamentals and fundamentals don’t change very quickly,” emphasizes Paldynski. “We are country selectors and our approach is to select countries that are most often masters of their own destiny. It’s not supposed to be a question of the business cycle,” concludes Paldynski.
The Attractiveness of Frontiers
Paldynski identifies local currency frontier debt as a particularly appealing investment opportunity “Frontier countries, characterized by lower GDP, favorable demographics, and strong growth potential, will eventually graduate to emerging market status,” argues Paldynski. “Given their high growth rates, these frontier markets can sustainably offer higher real yields, which is what the investor should be looking for.” Many countries have escalated their debt levels in the wake of the pandemic, and Paldynski contends that “the most politically viable approach to addressing this debt is to grow out of this debt. Frontier markets emerge as some of the most promising avenues for growth.
“Given their high growth rates, these frontier markets can sustainably offer higher real yields, which is what the investor should be looking for.”
One advantage of investing in frontier debt is the lack of overcrowding. “The proportion of foreign investors is typically below 10 percent in frontier local currency markets,” notes Paldynski. This implies that the behavior of local investors carries greater influence. Consequently, there is less likelihood of witnessing mass withdrawals by foreign investors during global risk-off events. “There are definitely no ETFs for these markets,” points out Paldynski.
Furthermore, frontier markets boast more pronounced return drivers compared to emerging markets, including local inflation and rate dynamics. “These factors are even more significant in frontier markets than emerging markets,” Paldynski remarks. “The culture in our asset management operations is to go outside of the benchmark and our venturing into frontier markets exemplifies this approach.”
