Passive strategies have reached nearly every segment of financial markets, including the more remote corners of emerging market (EM) local currency debt. While passive strategies offer broad exposure to these markets, they often fail to navigate the complexities and idiosyncratic risks unique to each country, including economic conditions, fiscal policies, political factors, liquidity dynamics, and more. These idiosyncratic risks make active management a more effective approach in this space, especially in risk-off environments.

Before examining the advantages of active management in emerging market (EM) local currency debt, it is important to first understand the role of local currency debt within a broader portfolio. The Emerging Markets Debt team at Aktia Asset Management – which runs three distinct EM debt strategies focused on hard currency debt, local currency debt, and frontier local currency debt – views local currency debt as a fixed-income asset class that offers high-yield potential but carries sovereign risk instead of corporate credit risk.

“In terms of yield potential, EM local currency debt is often compared to investment-grade and high-yield corporate bonds,” says Mikko Kuisma, Portfolio Manager within Aktia’s Emerging Markets Debt team. “However, when it comes to risk, the key difference is that we are shifting from corporate credit risk to sovereign risk.” Within the fixed-income spectrum, EM local currency debt competes with high-yield bonds but with government rather than corporate risk. “That changes the dynamics somewhat. For us, it’s all about the government risk analysis, as our investment universe excludes corporates, including state-owned enterprises (SEOs) and quasi-sovereign entities,” Kuisma adds.

“In terms of yield potential, EM local currency debt is often compared to investment-grade and high-yield corporate bonds…the key difference is that we are shifting from corporate credit risk to sovereign risk.”

Mikko Kuisma

Unlike corporate bonds, which are tied to the financial health of individual companies, local currency debt is influenced by a country’s economic stability, fiscal policies, and political landscape. “The drivers for emerging market local currency debt are somewhat different,” explains Kuisma. “It is more influenced by economic cycles, local inflation, and, of course, political risks play a much larger role,” says Kuisma, who co-manages Aktia’s local currency EMD strategy alongside Kaj Paulamäki.

“The drivers for emerging market local currency debt are somewhat different. It is more influenced by economic cycles, local inflation, and, of course, political risks play a much larger role.”

Mikko Kuisma

An EMD local currency portfolio, according to Kuisma, can be more diversified than a typical corporate bond portfolio, which is usually driven by global risk sentiment. “We invest globally in countries at different stages of their development. These countries often have better growth potential, supported by a younger population and other long-term development factors,” explains Kuisma. “With sound fiscal and central bank policies, we believe these markets have the potential to outperform over time,” he adds. “These are the key factors that drive and support the broader universe in the long run, but obviously the country-selection matters a lot and it’s important to conduct an in-depth analysis to find the markets that offer opportunities and avoid those with unfavourable prospects.”

The Benefits of Active Management

Active management offers significant advantages in mitigating idiosyncratic risks – risks that passive strategies, which must invest in all markets within an index, cannot avoid. “The big difference between bonds and equities is that with equities, you face unlimited upside, but in bond markets, you have limited upside and potentially unlimited downside,” Kuisma explains. By investing passively across all markets, “you’re exposed to a wider range of idiosyncratic risks, which means you face more downside without exposure to proportionate upside,” according to Kuisma. “That’s why selecting the right countries and bonds is much more important.”

Kuisma sees healthy competition between active and passive investing in the future, particularly in local currency debt markets, which requires true active managers such as Aktia to constantly seek pockets of alpha and continue refining their investment process. “In today’s volatile world – driven by both local factors and geopolitics – active management is the best way to gain exposure to EM countries,” he asserts. “Our goal is to avoid the potholes and geopolitical hot spots in our portfolio because in our experience, taking these risks is rarely rewarded, especially in the bond market.”

“In today’s volatile world – driven by both local factors and geopolitics – active management is the best way to gain exposure to EM countries.”

Mikko Kuisma

Passive investing is also limited in terms of the instruments available to access emerging markets. “In some markets, we might use FX forwards, FX derivatives, or even AAA-rated bonds issued by development finance institutions in the same currency,” says Kuisma. “But overall, passive investments are constrained by the instruments available and the countries you can invest in. Taking an active view opens up many more alpha opportunities.”

Case in Point: 2022

The importance of active management became especially clear in risk-off environments such as 2022. “That year is a prime example of how idiosyncratic factors can drive market returns,” notes Kaj Paulamäki. “This is a better environment for us because country selection plays a much bigger role, compared to a globally strong bull market where everything rallies,” he elaborates. “In such conditions, active managers can generate significant alpha.” Aktia Emerging Market Local Currency Bond+, for instance, ended 2022 with a gain of 1.3 percent in Euros, while its benchmark suffered a low double-digit loss.

“That year [2022] is a prime example of how idiosyncratic factors can drive market returns. This is a better environment for us because country selection plays a much bigger role, compared to a globally strong bull market where everything rallies.”

Kaj Paulamäki

“The performance difference was partly driven by the war in Ukraine, particularly due to our decision to exclude Russian government bonds from our strategy. We haven’t invested in Russian government bonds since 2014,” recalls Paulamäki. Even without the Russia-exclusion factor that contributed to outperformance, Aktia’s strategy still generated positive alpha that year. “There were many country-level drivers at play, including inflation dynamics and how central banks in emerging markets acted more swiftly to tame inflation compared to their Western counterparts. It was an environment where our strategy tends to perform exceptionally well.”

The Traffic Light System

A key component of Aktia’s active management approach is its well-defined Traffic Light System, which guides decisions on whether a country is non-investable, partially investable (no government financing), or fully investable. “The Traffic Light System is at the core of our approach,” states Paulamäki. “It assesses each country’s fundamentals and sets limits on which markets are suitable for us, reflecting our investment philosophy centered on country fundamentals and long-term horizons.”

“The Traffic Light System is at the core of our approach. It assesses each country’s fundamentals and sets limits on which markets are suitable for us.”

Kaj Paulamäki

The system is data-driven, relying on around 50 indicators – including environmental, social, and governance factors – to evaluate a country’s prospects. “Our in-house data tool tracks over 140 countries, including emerging markets and frontier markets. These 50 indicators, two-thirds of which are considered ESG data, provide a comprehensive view of a country’s development trajectory,” Paulamäki elaborates.

“Ignoring these factors [ESG factors] would leave a significant gap in our understanding of a country’s potential for long-term positive development.”

Kaj Paulamäki

He further explains that the governance component includes aspects such as human rights, stability, and political environment, while the social component covers welfare, infrastructure, human capital, and climate. “Ignoring these factors would leave a significant gap in our understanding of a country’s potential for long-term positive development,” argues Paulamäki. “More broadly speaking, our thinking is that ESG is an important part of economic analysis.”

The Allocation Process

The allocation process involves evaluating the carry returns in each country. “The key is to assess the level of carry a country offers, as it is one of the most stable performance factors,” concludes Kuisma. “We are carry-focused investors. We examine whether the carry adequately compensates for the fundamental, country-specific, and FX risks,” he emphasizes. “Many emerging market countries offer very high yield levels, providing a solid starting point for investing in emerging markets.”

“We are carry-focused investors. We examine whether the carry adequately compensates for the fundamental, country-specific, and FX risks.”

Mikko Kuisma

Through active management, Aktia Asset Management seeks to navigate the complex dynamics of emerging market local currency debt, turning idiosyncratic risks into opportunities for enhanced returns and risk mitigation.