EMD: An overlooked potential source of yield for insurance investors

STEWART: Welcome to another edition of the Insurance AUM Journal podcast. My name is Stewart Foley, and I’ll be your host standing with you with the corner of insurance and asset management. Today, we’re here to talk about complementary approaches to managing emerging market debt for insurance companies. Today we’re joined by Damien Buchet, CIO at Finisterre Capital. Welcome Damien.

DAMIEN: Thank you very much.

STEWART: And Nick Varcoe, portfolio manager of EM Strategies at Principal Global Investors. Welcome Nick.

NICK: Thanks for having me.

STEWART: Thanks for being on guys. It’s great to have you. So, important topic, right? Insurance companies are starving for yield. We all know that.EMD is interesting because it offers a lot of yield and a lot of diversification characteristics. So that’s fine, but the markets have come a long way. So what’s your outlook on EMD today and how the EMD market… Kind of two questions, how the EMD market has changed in recent years?

NICK: We remain constructive on emerging markets. The market has evolved over the years and we really like the supportive technicals that emerging markets continue to offer, continued attractive relative value versus its developed market comparables. We really think that the EM fundamental recovery that we saw begin to occur in 2020 has some upside into 2021 led by strong growth out of Asia and in particular China. This growth is very supportive for commodities, particular base metals, copper and iron ore, and continue to think emerging markets looks attractive in this environment.

STEWART: So Nick, how you come to this market is as an insurance investor, US dollar based higher quality. As I understand it, right? That working inside the world of insurance constraints is your daily job?

NICK: That’s correct. The constraints in particular really come down to ratings and looking for the best return on a risk adjusted basis. The majority of what we will be doing will be investment grade rated. And in particular it’s probably something more like a 90% weighting towards investment grade bonds. So that’s really what drives our relative value. And in that regard, that’s where we tend to look at it more versus what opportunities exist in developed markets, and what can we deliver on an investment grade basis from an EM standpoint.

STEWART: And on the other end of that, Damien, you operate in a total return unconstrained environment,

can you talk a little bit, what’s your market commentary outlook and the recent changes in the last few years?

DAMIEN: Right. I would echo Nick to highlight that EMD remains often overlooked as a new opportunity set for global investors when it comes to their search for yield, a need for diversification, which are very real investment needs these days. So it’s a fact that our universe has broadened in scope, has improved in terms of depth, liquidity, availability of instruments, both cash instruments and derivatives. And so that makes for a very complete, you could say complex marketplace, but from which so many opportunities can be extracted. So, compared to what Nick does, I would actually represent a complement to Nick’s approach, which tends to be more balance sheet focused.

Finisterre Capital would position themselves as a provider of solutions to insurance companies trying to come as close to the needs of the insurance company is in terms of generating the right risk return profile with low volatility, emphasis on income, limitation of capital losses, but using a much wider opportunity set, which these days offers a lot of potential. Yes, we remain positively minded towards EM debt out of the US election, and out of this pandemic. But we’re fully mindful that if you look back 15 years, your best friend has remained income throughout. There is no discussion about that. But your beta element, your capital gain component, hasn’t proven to be sustainable. And that’s what we need to work on in our approach.

This means that your manager probably needs some extra flexibility in the way they manage those mandates. So, yes, we’re coming out of the pandemic, but it doesn’t mean it’s a risk-free environment for all of us and for risky assets globally. Hence we need to pay attention to the parameters of this recovery. What it means for future US policy moves, we have to adjust our growth inflation expectations versus the attitude of the Fed. And these days the degree to which rising US yields are driven by real or breakeven yields is a major issue. All of those are challenges we need to address.

STEWART: Yeah, it’s huge. I think you’re exactly right. So the one thing, I think a lot of times, whether you want to admit it or not, I think a lot of investors, insurance investors perceive a higher degree of volatility and risk in EMD. And I would say that is largely a misperception, but it’s there. So what risks do you see in the market? I’ll go to Nick first. What risks do you see? And what’s the most effective way to mitigate it? And then we’ll talk to Damien just a second, about the same question.

NICK: Great question. And I’ll start with just the changes in the makeup of emerging markets and in particular with an investment grade focus overthe last five to 10 years. This is a market where you’ve seen significant changes, where you’ve seen countries like Brazil, Russia, Turkey, and South Africa fall from investment grade to below investment grade or high yield. We’ve seen Russia come back and regain investment grade ratings, but those are four meaningful issuers that were great sources of spread and yield for insurance companies in that investment grade realm. We’ve now seen that change a little bit in that they’re not as frequent issuers, they’re obviously still out there, but not as frequent issuers. And we’ve seen significant issuance in the last couple of years from different sources, namely China and the middle East.

And with those issuers now in the market, they bring different risks, but there are also different ratings as well. You see significantly higher ratings from both of those regions, but the Middle East – very highly rated countries that offer decent spreads and decent yields in particular over their developed market counterparts. So, different regions of the world, different spreads, but completely different makeups from what we’ve seen historically there.

STEWART: So Damien, same question with a little bit of a twist. So, a lot of people would say, I’ve heard the argument, “Hey, China’s not an emerging economy.” Is China EM? Should it qualify as EM? So, what’s you view of the market risk at this, and to next point, China specifically?

DAMIEN: My argument would always be that, being a total return, very active investor in EMD and focused on delivering a desired risk return profile, I would answer that you can’t paint all EMD with the same brush. If you think about the two main traditional asset classes in this space, hard currency debt, whether sovereign or corporate, that’s a credit asset class. I would argue that it’s a fairly low volatility asset class on an ongoing basis, but it suffers from regular gap risks, sudden liquidity crisis. And the question becomes, how do you manage those sudden drawdowns in this asset class? That’s been the typical feature of how crisis occur in the hard currency credit space in EMD.

But not so much about volatility. On the contrary, when it comes to local currencies, you’re dealing with a fairly liquid, a fairly deep asset class, which has expanded a lot or in terms of investability over the past few years, but which exhibits perennial volatility and arguably from a risk/return standpoint, or even in terms of capital charges, it’s not the most optimal place to be strategically so you have to use these various asset classes in the right way in a portfolio, if you want to remain efficient from a risk return standpoint, but also from a capital charge standpoint. And the answer I would make is local currency has to be used for what it is.

It’s a great tactical booster, a great provider of capital gains, a very rewarding asset class for your macro views, much more so than external debt. But at the same time, it can’t be a strategic allocation in your portfolio. So, you have to juggle with these imperatives, but at the end of the day what matters is very much, what risk return do you want to extract and how do you manage to build the right portfolio to deliver just that?

STEWART: That’s a great answer. I don’t know if my next question is going to be, you may have already answered part of it. But one of the complexities of EMD is navigating hard currency versus local, corporate debt, versus sovereign. What are your views to both of you, but what are your views of the segments inside of EMD?

DAMIEN: Maybe I’ll take that first, but we have a strong view that these distinctions are fairly artificial.

STEWART: That’s interesting.

DAMIEN: It’s a segue to your previous question on risk. We haven’t discussed default risk. Which of course should be very important from an insurance standpoint. But there’s an interesting feature about defaults in emerging market. The fact that even though emerging markets don’t necessarily exhibit higher default risks over the long run on average than the US credits and high yield or European high yield markets, we do tend to see peaks in default around global crises. But interestingly, a lot of the systemic default risk in EMs tends to aggregate around specific sovereign situations.

So when you have a large portfolio of corporates, you’re still very sensitive, highly sensitive to mostly sovereign risk. And to your last question, then the distinction between sovereign debt and corporate debt is just about the way you analyze the issuer. But in terms of behavior, we think there is a continuum in terms of the degree of sovereign-ness you have in a given name’s behavior from the pure sovereign to the quasi sovereign name, to a large corporate, which has a systemic importance for that country. At the other end of the spectrum, you have the purely private high yield company, which has the lowest degree of sovereign synchronicity, if I may say this way. And the same holds for local currency where not all markets are highly volatile, contrary to what the textbook would say.

STEWART: So, everybody talks about ESG these days. We’ve got articles on ESG, we’ve done some podcasts. How do you think about ESG standards or is it a factor in EM countries? There’s no standard. I think we’re all struggling for a standard period, but how do you think about ESG standards in any EM countries?

NICK: Sure. I can start there. That ESG considerations is something that we have utilized and incorporated into our analysis for the last few years now. It is becoming more prevalent in the emerging markets. We are beginning to see it more frequently. It is in pockets of the world, may be more prevalent in Europe to start, but we’re definitely seeing it more from a US standpoint, from an insurance company standpoint here. Maybe they’ve been a little later to the game per se, than some of the developed markets, but we are beginning to see that analysis come in and we do lose maybe on our side, a more definitive set of criteria.

In particular, from a sovereign standpoint, we’ve been asking the questions we’ve been seeing this posed our way more often. We just don’t have necessarily an accurate and equal comparison yet, we do have it a little bit on the corporate side because we’ve got the structure or the framework from some of our DM counterparts.

As Damien mentioned a little bit earlier, we do see a little bit different on the corporate side that you do see more conglomerate or family ownership structures in EM than you would in DM. And that’s going to affect the G score in the ESG component. And it really becomes even a little more unique in that we tend to have a little bit more on the exporter front. We see more commodity names here, and we also see more corporates out of China, which presents a very unique opportunity or unique situation because a lot of their names, a lot of the corporations we’ll see there will be higher on the investment grade rating scale on different ESG considerations on a governance standpoint and on a carbon and emissions footprint as well.

STEWART: Well, I think you make a good point. You talk about not having a standard in EM, I think it’s very arguable that there’s not a standard period. We all want a number… I want what’s my ESG score? Well, it isn’t that easy as you know. You’re talking about a host of criteria. You’ve got, what’s the G when you’ve got a Chinese corporate, what is it? How do you figure it out? So, I think that it’s interesting that it’s definitely on your radar screen and it’s something that you think about. Damien, how do you address ESG? Is that a factor for your strategies? Can you talk just a little bit about that?

DAMIEN: It is factor. We’ve long been convinced that a government that’s heavily corrupted, that mistreat their citizen has a fairly shorter shelf lifeand, as fixed income investors, we are going to buy bonds, which pay us back in 10 years time, we want to be paid in 10 years. We want the country to be solvent then. And the same goes for corporates. Corporates who engage in risky environmental projects with massive litigation risk. We’ve had examples in Brazil in the recent past when it starts to become a problem, then you’re sued by both Brazilian and US authorities. So, clearly these are things which, as an investor, have to be fully aligned with our interests. Now the question becomes, how do you quantify that? And what kind of attitude do you want to have to that, especially if you want to start making an impact, because we’re convinced that we are in a unique seat to be able to impact on behaviors through our interaction with governments, with corporates all year long.

Yes, we are in a unique position to bring a message home to these people. So the question becomes quantifying first at the issuer level, at the portfolio level… It’s an evolving landscape. We’ve made some choices at Finisterre and PGI to onboard certain scoring systems. So we are able to provide that, but it’s more about the qualitative assessment that the analyst makes as well.

STEWART: Yeah, absolutely.

DAMIEN: Eventually it’s what you choose as an attitude. We think, for example, that in EMs rather than an absolute score, it would be best to reward the would-be improvers and punish the ones which are relatively well-scored, but are doing nothing to prevent their fall from grace. So, it could be the case that no one is going to be like Sweden in EMs.

STEWART: Yeah, that’s right.

DAMIEN: So you probably want to reward a very badly-scored country or an issuer who’s doing real efforts to improve on ESG. And so that’s what we’re looking at in our scoring system as well. A more dynamic approach to reward improvement and punish deterioration.

STEWART: Yeah. And I think there’s two things there. It just makes sense that paying attention to ESG from the issuer makes a good investment. It’s arguable that, that is good for investing regardless of what the ESG score is. It’s a good investment characteristic of when you’re looking out for that. Insurance companies are uniquely positioned because long run paying attention to ESG impacts the liability side of their balance sheet. Extreme weather of events, it’s certainly is detrimental to the insurance industry, as just straight up cause and effect. So it seems like insurance companies, and I think you’re seeing a growing number of insurance GA become PRI signatories, for example, and really take that seriously.

So I want to kind of, just a little bit of a different, and I think given the fact that you guys are in two different ends of the spectrum with regard to insurance constraints, maybe ask each of you the same thing. So with various currency exposures, Nick, how do you deal with hedging, derivative management and currency translation risk? And then we’ll have Damien touch on the same thing.

NICK: From an EM standpoint, when it comes to US insurance investing, we’re very mindful of currency risk. And obviously when we’re involved in the corporates, quasi sovereigns and sovereigns, it’s a significant consideration. At our portfolio level right now, the hedging and derivative management and managing of currency isn’t a part of our active management in our insurance strategies right now, the majority focus of our insurance company has tended to be US Dollar denominated assets. And it hasn’t necessarily delved into local currency at this juncture or potentially even looked at hedging.

It has primarily been more of a buy and maintain strategy. And if we had seen corporate quasi or sovereign situations evolve to the point where they had gone below investment grade or move to high yield, our strategy based on our current constraints had been more to view an exit opportunity as opposed to a hedging strategy. So, as currently constructed with our current constraints, we don’t typically get too heavily involved in currency hedging, derivative management, or hedging.

STEWART: Thank you. Damien, how about you? Can you talk a little bit about hedging, derivative management and so forth?

DAMIEN: Yeah. So as you mentioned, we’re at the other end of the spectrum versus Nick on this one, because we’re actively involved with currencies. Not that currencies are a huge part, as I said, we want currencies for what they are, which are a tactical opportunity, even if within currency, not everything is volatile. We have perfectly sustainable opportunities in the local currency space, whether local bonds in Peru or Egyptian treasury bills, which wouldn’t really react much to market movements, which are great income opportunities, et cetera. But no, when we take, when we decide to take active currency risk, we take it, we don’t hedge it, but it’s true that the portfolio will be quite active, as such we’ll be using a lot of derivatives, not complex ones, but simple ones, interest rate swaps, credit default swaps, FX forwards to materialize currency risks on the long or the short side.

Now, I would say the bulk of our use of derivatives is going to be with a purpose to decrease risk. As I said, our value proposition is to deliver the bulk of the market upside, 90% or more, for half the volatility and half of the downside, potentially. So a very asymmetric risk return profile, which relies a lot on income as a primary source of performance. So the starting point is always income for us. The use of derivatives around that is essentially in order to help us deliver this risk/return profile. A portfolio like ours in an insurance context would potentially be subject to potentially look through, but it would also change a lot, but hopefully we would come as close as possible to the expectation of an insurer, which is to mitigate the risk and mitigate draw-downs. And part of that is about derivative usage as well. Yes.

STEWART: So if we can just real quick from each of you, and then I have a surprise question, so don’t worry. What would you encourage as an insurance general account investor when they’re looking at EMD in 2021, what should they be looking for?

DAMIEN: My take is, they shouldn’t be afraid. The trends over the past few years after every crisis has been for strategic investors, especially asset liability managers at the global level, to step up their average EMD allocation. Why?TherecognitionforEMDbeinga great source of yield and diversification is now near universal. Now, the pressure is proportionate to the level of yields you can get in your home market. And I must say, when I look at the allocation between European insurers and US insurers, European insurers are maybe more advanced, probably for the wrong reasons, which is that they’ve been looking for yields for longer in a European context. So the US insurance community may come to that point and EMD is a great answer to that.

STEWART: That’s great.

DAMIEN: So I think, in terms of risk, rewards, and outlook, we are still very positively minded, we think this is a universe that can provide a lot of upside for insurance companies in a risk controlled manner. And that’s essentially what Nick and I are focused on providing even though we operate at different ends of the spectrum and different positions in the balance sheet.

STEWART: Very cool. So, here’s the surprise question. You ready? I asked this question at the end of every podcast and those of you, I’m sure you guys have listened to all of them. So, you know it’s coming. Here it is. So we’ll start with Damien. Here we are. Now, it’s your graduation from your undergraduate university. So you’re about 21 and you’re looking smooth. You get your mortar board on, you get your robe on, you’re looking good. So, you get up on stage and you walk across and the president of the college or university hands you the diploma, gives you a firm handshake and wishes you well, and you come down this stage on the other side, you come down the steps and you meet you today. What do you tell your 21 year old self?

DAMIEN: Right. I would tell them to follow your instinct and stick to what you believe in all along. That’s what I did. I married myself to emerging markets 30 years ago. I stuck through all crises and all you need is conviction and passion…

STEWART: God! That’s great advice.

DAMIEN: In these markets. So it’s conviction and passion about what emerging markets really are. It’s less about loving finance to be an emerging market player. It’s more about loving these countries, understanding them for what they are. Political context, economic context, and the human context. So that’s a great universe to go through, to live on and off. You’re always surprised. Every morning is a new day. So that’s what I would tell them.

STEWART: God. That’s great. I teach students and I love it because they need to hear that. So, okay, Nick, so it’s your turn in the hot seat. Its you, here you are. You’re at the university of Northern Iowa. I’m a Mizzou guy. So we’re from the same neck of the woods. The farther you are, you’re away from home, the bigger home is. So I’m counting you as home. So there you are. You’re 21, and if you’re as clueless as I was, you needed some advice and you run in to Nick today. What do you tell your 21 year old self?

NICK: I think this is a great question on the heels of the pandemic that we’re coming out of, frankly. And I’ve been at Principal almost 20 years now, straight out of university. And prior to March 1st of 2020, had never worked a day from home in my entire life. And haven’t worked a day in the office since, and it really leads me to believe that no two days that we are going to spend in the markets are going to be the same, but you have to draw on your past experiences in the market to pick where things are going to go next. You have to use that analysis from where you’ve been to anticipate where we’re going while also realizing that this crisis is completely different than what we saw during the great financial crisis. And it’s different than what we saw during the telecom crisis right when I started my career 20 years ago.

So it really comes down to the idea that you’ve got to be mindful of where you’ve come, but very excited about where the future is going to take you and really be mindful of the risk and the return that presents itself.

STEWART: That’s good stuff. Thank you very, very much both of you guys. Thanks for being on the line.

NICK: Thank you.

DAMIEN: Thank you.

STEWART: Yeah. So that is opportunities across the EMD spectrum with Nick Varcoe and Damien Buchet. My name is Stewart Foley. If you like what we’re doing, please like us on all the major podcast platforms. If you have ideas for future podcasts, please email us at podcast@insuranceaum.com. I’m Stewart Foley, and this is the Insurance AUM Journal Podcast.

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Risk Considerations

Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. Risk is magnified in emerging markets, which may lack established legal, political, business, or social structures to support securities markets. Emerging market debt may be subject to heightened default and liquidity risk. Fixed income investment options are subject to interest rate risk, and their value will decline as interest rates rise.

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