Stewart: Real bond yields are at an all time low. And we’re here today to talk about emerging market debt with Samy Muaddi, EM Debt Portfolio Manager at T. Rowe Price. Samy, welcome.
Samy: Stewart, thank you for your time and look forward to speaking with you today.
Stewart: You, too. My name’s Stewart Foley. This is the Insurance AUM Journal Podcast. Samy, you hold a distinction here as one of, I think, you may be the only, well, one of the only repeat guests we’ve had. So thrilled to have you back on. And so when we talk about EM debt, it encompasses a broad range of sometimes disparate assets. It would help me, I mean, I always learn the most, I think, on these podcasts, could you give us the lay of the land as far as the size, region, credit quality and so forth and how you define the opportunity set?
Samy: Sure thing. And thanks again for the opportunity and the platform. And I would take a step back and just first describe the emerging market debt asset class as being one that’s at the intersection of global capital markets and economic development. So a lot of these countries that we’re going to speak to today don’t have access to equity capital markets, don’t have access to private equity. Really, when a developing country first engages with the world in financial markets, they begin in the emerging market debt asset class. Beyond finance, to succeed in this industry you have to solve for a range of complexities, those of society, business, politics, culture. It definitely takes a diverse team and a diverse skillset to do that. Some of the skills needed are credit risk, macroeconomics, applied history, even political science, psychology and emotional control when you’re in a credit cycle and portfolio construction.
Samy: And if you can solve for that, there’s a real great opportunity, both from a secular perspective and a cyclical perspective, to put on book yield and to compound interest. It’s an asset class speaking to hard currency sovereign debt, the longest lived of the versions of emerging market debt. That asset class has compounded a 900% return since 1994*. That’s about eight and a half percent annualized. And you’ll struggle to find an asset class that’s outperformed that, other than, I’ll concede, the U.S. equity market. But beyond that, come for the carry, but stay for the ability to have access returns. And so when we kind of peel back the layers of the onion, there’s emerging market local debt, which certainly is a higher volatility asset class. And I would kind of remove that from the compounding case, because while it is a $3 trillion high-yielding market, you’d be taking on local rates, risk and importantly, currency risk.
Samy: So the ability to compound for insurers resides more in the credit market, in particular, the dollar-denominated credit market. And there, it’s a sizable opportunity, $2 trillion in emerging market corporate debt, another trillion and a half in emerging market sovereign debt. In aggregate, the EM debt asset class is comparable in size to U.S. Investment Grade bonds, but it has a fraction of the sponsorship in the insurance industry that you would find from traditional developed market investment grade credit.
Stewart: Yeah. I mean, I think that you brought up the myriad of things that have got to be considered when you’re investing in EM debt and then you layer on top of that. And I know you deal with a large number of insurance clients, and you’re also dealing with their eccentricities, and operating constraints, and regulatory rating constraints as well. So we’ll get more into that, I know, in just a little bit. But just drilling down a bit more on that within the EM dollar credit market, how do you think investors should think about sovereigns versus corporates in terms of risk and return?
Samy: Yeah. So good question. In both cases, I think insurance clients should consider emerging market sovereign debt and emerging market corporate debt in tandem. I think they’re asset classes that should both be considered. Traditionally, and you started with the right comment, we’re in an environment of negative real yields in most developed market fixed income. Traditionally, where a client may go in public markets would be to U.S. high yield. But that market has not grown to a considerable extent. In fact, it stayed stagnant at around a one and a half trillion dollar market in the last five years. To put one and a half trillion dollars in context for U.S. high-yield bonds, I could find you five stocks today, mostly tech stocks in Aramco, that have a market cap that’s greater than one and a half trillion, so single stocks that have a market cap greater than the entire U.S. high-yield bond market.
Stewart: Yeah. It really puts it in context, right? I mean it-
Samy: It really does.
Stewart : Yeah. And you go, “Wow!” I mean, as you were walking down that path, I was like, “Ah, yeah, that makes total sense.”
Samy: So in layman’s terms, what it means is if you want to reduce your equities and buy some high-yield bonds, there ain’t enough bonds to go around. And I think that’s partly why people are moving into emerging markets, particularly insurers that maybe haven’t had programs there before. So those two flavors on the hard currency side, emerging market sovereign and emerging market corporate, certainly there’s a case for both. But I think when you peel back what’s underneath, you’ll find that the emerging market sovereign asset class is a more limited opportunity for insurance clients, because about 30% of the available yield in EM sovereigns is coming from more distressed credits. So sovereigns that are either in a default or on the verge of default. They contribute around 30% of what, on the sticker level, is a five and a half percent index yield. And most insurance, they can’t put on CCC or distressed credit.
Samy: We’re trying to maximize yield relative to capital charges. Whereas, in emerging market corporate that ratio is much lower. The CCC market is a low single digit percentage of the debt outstanding. The yield-to-volatility level, the yield-to-capital charge level, is much more attractive. You’re looking more at the mainstream market asset classes versus the frontier market. And we find that pairs a bit better for what our insurance clients need. Certainly, there’s a case to do both, but in a non-insurance account you probably have a sovereign anchor and then a corporate pairing. In the case of an insurance client, we think that that ratio should be much more equitable, if not anchored more towards the corporate side.
Stewart : And you’ve tossed this number out and the number that I have is EM corporates are two and a half trillion dollars today, yet they’re not nearly as widely held as some smaller asset classes like U,.S. high yield and one that you hear a lot about, bank loans. So what’s behind that? And is that changing? And why is it changing, if it is?
Samy: Yeah. So certainly, and I’m speaking from the perspective of someone that’s been in the emerging market corporate industry for 16 years, so back in 2005, 2006, we didn’t even have a benchmark until 2011, 2012. So part of it is just an internal reason, it’s a new asset class. And a new asset class needs to kind of prove itself through gradual adoption. I can think back to the first industry events, there was kind of a key industry conference back in 2011, 12. You had maybe a couple dozen people there. Today, that conference, either virtually or physically, would have hundreds of people attending. The asset class through that time period has been tested through the Eurozone crisis, the taper tantrum, the commodity bust, obviously, COVID and more recently.
Samy: And so I think that gradual adoption being tested through multiple cycles has certainly led to a bit of a hockey stick in terms of the growth of sponsorship for the asset class in terms of dedicated assets. But there are also external reasons. And you highlighted those external reasons. I mean, effectively, I’m an EM guy, so pardon me using EM language. The developed market bonds, U.S. Treasuries, U.S. IG, European analog there for Eurozone bonds, they’re in an environment of financial repression. And we use that term financial repression in emerging markets. It’s something we see all the time. It’s when the policy rate is deliberately kept below the level of inflation. So effectively, you financially repress the bond market. We could debate the motives. Usually, in emerging markets, it’s a nefarious motive, because the government’s trying to manage out of a debt crisis, certainly a different case for a reserve currency nation.
Samy: But whatever the motive, the results are the same. If you own a Treasury, if you own a U.S. IG bond, five year, 10 year, you’re earning below inflation. And so I think that’s the external factor that’s also accelerating the sponsorship for this asset class that has already had a 10-year resume to present to prospective clients of pretty decent compound interest.
Stewart: You bring up a really good point. So you have a monetary policy that’s got the rate held down, really held down, inflation high. And that creates a real problem for insurance companies. I mean, they’ve got a regulatory influenced large allocation of fixed income securities, which inflation is detrimental to the valuation. And then they’ve got claims on the other side that are fully affected by inflation. And so it’s a very difficult Gordian knot of a problem for insurance companies given all the constraints they’ve got to manage through and also their operating realities. So, Samy, T. Rowe Price manages money for a lot of insurance companies. What are those mandates looking like? Do they differ from an institutional investor in another segment? How have you been working with your clients to fit EM assets into a general account portfolio?
Samy: Yeah. Anytime you’re on a general account balance sheet, it requires a very close partnership and a customized solution. So there’s no à la carte service here. It’s a long dialogue and a long partnership with the client. We have some that are high-yield focused, some that are investment-grade focused, in all cases, trying to maximize book yield relative to capital charge, trying to minimize the risk of impairments and trying to achieve typically, a bogey overdeveloped market credit. That’s why they’re coming down on us to get 1% over U.S. IG, one and a half to 2% over U.S. high yield, at the same rating category. The high-yield accounts typically are B or better. The IG accounts typically know very limited tolerance to take downgrades and try to keep that into account in our underwriting.
Samy: And I, for someone that’s been involved in emerging markets for a decent time, I very much welcome clients that behave in this way, long-term, thoughtful investors. Our asset class in the 1990s experienced a lot of volatility in its sponsorship and its capital flow. So I very much welcome insurance clients coming into this industry who have a long-term focus. And back to my opening point, I said that this is an asset class that’s at the intersection of global capital markets and economic development. When you have investors coming into developing countries with a short-term time horizon, they could do a lot of ill in those countries. Money moving in, money moving out causes a lot of problem in managing the balance of payments for a developing country.
Samy: When an insurance client comes in, certainly you have to do your job in underwriting to avoid the mistakes, avoid the downgrades. But when they take that long-term horizon, 10 years, sometimes even longer, 30 years, that’s the best thing that can happen in underwriting for a developing country. And that’s a mutually positive reinforcing outcome when the country can actually have dedicated capital that sticks for a long time, they can make good policy decisions that are in the best long-term interest, both of the economy, it’s growth potential, and also the investors to whom the capital has been trusted within their borders.
Stewart : Yeah. I mean, you’re describing a collaborative arrangement that’s beneficial to everybody. The insurance industry, one thing that is not, is fast money. So over the past two years we’ve seen a fair amount of market up and downs, the volatility in China high yield being the most recent. When you take stock of EM fundamentals and valuation, how concerned are you about issues like inflation and resurgent populism in Latin America, for example?
Samy: Yeah. So T. Rowe’s been investing in emerging markets since the 1980s. We’ve seen a lot of cycles. We’ve seen micro cycles, macro cycles. And it’s all about having an established process to be able to get the pattern recognition necessary to succeed. So with respect to that process, I teach a graduate course on this at Georgetown University. It’s about 45 hours of lecture time. I’m going to try to deliver it to your listeners in about 45 seconds. So when a country is engaged in capital markets, a sovereign nation, let’s start there, you can solve for all the complexities that I started with down to one risk factor, which is market access. If a country can access markets, it can stay solvent. Japan is solvent with debt-to-GDP near 300%. In our career, I’ve seen Ukraine and Mexico go bankrupt with debt-to-GDP of 30%. So in our framework, a country needs an anchor, an anchor to maintain market confidence to maintain market access.
Samy: Those anchors could be one of four things, four parts of the framework. The first is the fiscal arithmetic, how a country interacts with its citizens through the ability to mobilize taxes. And then therefore, sustain debt-to-GDP in a level that’s commensurate with continuing to market, to access markets. The second would be the external and monetary side, so how a country interacts with the world through its balance of payments that creeps or extends foreign currency reserves, and then the credibility of the central bank to manage that process. The third anchor potentially could be the politics and specifically, the institutions of those countries and whether or not they’re capable of credibly maintaining investor confidence through a cycle.
Samy: Fourth and final would be the contingent assets and liabilities of the country, so the off balance sheet assets, perhaps sovereign wealth funds or resources, or off balance sheet liabilities, potentially the cost of energy transition or the cost of bailing out a banking sector. If a country can maintain at least one of those four anchors, in our experience, it’s very likely to continue being able to have market access and avoid a sovereign distress scenario.
Samy: So now, answering your question on inflation and resurgent populism in Latin America within that framework, so the inflation question comes within this external monetary pillar, that external monetary anchor and what is the credibility of a central bank to manage inflation in line with its target? So the good news here is that we’ve had a growth of central bank independence in the likes of Chile, Brazil, Peru, Indonesia. And so our comfort with their ability to manage through this adjustment is very high, especially relative to history. We’ve seen this done poorly in the 80s and 90s. On the other hand, this is the very reason that a country like Turkey is struggling and why I have not ever underwritten a Turkish asset for an insurance client, because the credibility of the central bank has been undermined, inflation is beyond control, and that’s having a reverberation through the credit market.
Samy: Secondly, on the resurgent populism in Latin America, what you want to do as an EM investor is divorce yourself from the media coverage, from the politics of personality. I have not read a newspaper in eight years. Now, I haven’t read a newspaper in eight years because I have access to T. Rowe Price research. But if you read the newspaper coverage on Mexico, you would have a lot of deep concern on AMLO. When you actually look in Mexico, when you actually look at his spending track record, he’s running one of the most conservative fiscal budgets, not just in Latin America, but in all developing or developed countries. So the actions of the person are very different than the media coverage of the person. And that gives us a lot of comfort in terms of being a contrarian in Mexico at this time.
Samy: Similarly, there’s a lot of concern on Chile. Chile has an election around the corner. They’re drafting a new constitution. As a long-term investor in this country, I actually see a lot of positives coming out of this. When you have my job, one thing you do is actually read constitutions from countries. And there’s one thing that every constitution in the history of the world has in common, is that they’re all written by men, either exclusively men or mostly men. Chile will have the first constitution in the history of the world that’s equitably written by both men and women.
Samy: So I think there’s a lot of positives coming out of this period. The constitution has been around since 1980. It was written by a military dictator. It’s okay for a country to move on from that. There’s a lot of checks and balances in Chile. We have a lot of confidence in the central bank to manage through this process. And it’s a country that we’re comfortable, even with a very long-term time horizon, to continue allocating capital during this period of political volatility.
Stewart: It just never occurred to me that someone like you is reading constitutions. I mean, that’s really interesting. And the point that they’ve never been written by women is mind boggling to me. I’m suddenly optimistic about Chile, too.
Samy: I’m so glad to hear that.
Stewart : Yeah. So if I’m an insurance CIO and I’m considering EM debt because of the characteristics that you’re describing, you like the risk return, profile, et cetera, so, and you kind of touched on this a little a bit ago, but talk to me a little bit about local currency versus USD EM. As an insurance investor, how should I be thinking about currency risk and when I’m investing in this asset class?
Samy: Yeah. So for a global audience, you have to have a different response for an insurer with a dollar profile versus a Euro or non-dollar profile. And the reason is EM currency outcomes are dollar dictated rather than EM earned. So if the Fed policy pivots in a direction towards a stronger dollar that has more of an impact to developing countries, the natural policy stance of those countries themselves, that’s part of being a dollar hegemonic reserve currency regime. So for a dollar-based insurer, we would recommend very small allocations to EM local currency bonds relative to EM hard currency bonds. The volatility profile of that dollar EM currency basis has not been commensurate with earning a very large capital allocation.
Samy: However, if it’s a Euro or it’s a dollar-based client, different answer. I think at that point, the EM currency performance relative to Euro, relative to Aussie has merited a larger allocation. And so we’d have to kind of partner with the insurer with that framework to figure out what the right ratio is.
Stewart: It’s a bigger discussion, right?
Stewart: Does it ever, and this is kind of an off-the-wall question and you can kick this aside if you want, but does that discussion ever get into the nature of the insurer’s liability and their exposure, their currency exposure, on that side of the balance sheet? Or is that just not typically part of the discussion?
Samy: No, it definitely does. I think before we build a general account asset solution for a client, we spend a lot of time understanding the liability profile. And so when I started before, there’s nothing à la carte on the T. Rowe Price emerging market insurance menu. It’s all highly customized.
Stewart: Right. It’s all made to order, if you will, if you stick with the menu analogy. So you mentioned you teach graduate courses at Georgetown. And I’ve been fortunate enough to teach a fair amount over the last few years as well. And I would be willing to bet a good portion of why you do it. It is not the lofty compensation. I would start there. But you have to have a love of helping people who are early in their career. You have to have a love of the students to do it, to do it well. And I’m quite sure, in knowing you for the last couple of podcasts, that you’re a very good teacher. I have no doubt about that.
Stewart: So the question is this. I want to take you back to your undergraduate graduation day. And you’re there. Your last name starts with M, so you’re kind of middle of the alphabet. You’ve had some time to think. They call you. You walk up the stairs. I’ve watched a zillion graduations as a prof. And they call your name and the crowd goes crazy. And they bring you out. You shake hands with the president, quick photo op, and down the stairs you go. Now, at the bottom of the stairs, you run into Samy Muaddi today. What do you tell your 21-year-old self?
Samy: That’s a great question. And I followed you along there in my mind. So it’s the same advice I give to my students, particularly if you’re entering this industry. When you enter this industry, it’s rare that someone relatively young is competing immediately with people who have done this for 20, 30 years or more. You enter financial services. You’re an investor. It’s game time when you start. And so you can’t change that experience gap in the first few years of your career. So there’s two things you can do to make up for it. One is, out compete. So just work more. And that’s a volume-based thing, to try to put the hours in necessary to catch up. And the second is, have an appreciation for applied history.
Samy: I mean, back in the early part of my career, especially before I had children, I’d read one book on emerging markets a week. That was the goal. And it could be anything. Pick up a country. You take a referral from a colleague or industry contact. And I think just through years of iteration, doing that early in my career and maintaining those same habits today, it helped me catch up sooner than I otherwise would have. You have to kind of internalize the position you’re in when you start in this industry early on and then just do what you can to catch up.
Stewart : That is great advice. Two different concepts I had never considered, the way in which you’re putting that, so, bravo. It’s great to see you again. I really appreciate… You obviously know your stuff on the EM debt side. But it’s great to see that you’re teaching as well. We’re kindred spirits in that way. So Samy, thanks for being on.
Samy: Hey, Stewart, thanks for the conversation. Thanks for your time.
Stewart: It’s always great to see you. If you have ideas for podcast, please email us at firstname.lastname@example.org. My name is Stewart Foley and this is the Insurance AUM Journal Podcast.
*Source J.P. Morgan
As of 12/06/21