Investing in Emerging Market Debt Using a Mosaic Approach

Stewart: Welcome to another edition of the podcast. I’m Stewart Foley, I’ll be your host. Today’s topic is Emerging Market Fixed Income, and we’re joined today by Polina Kurdyavko, who is the head of emerging market debt and BlueBay senior portfolio manager at RBC Global Asset Management. Polina, welcome. Thanks for being on. Thanks for taking the time.

Polina: Thank you so much, sir. It’s a pleasure to be here.

Stewart: All right, we’re going to start this one off like we start them all. What is your hometown, like where you grew up, a fun fact and what makes emerging market debt so cool?

Polina: Well, I was born in a very small town called Obninsk, which was still in Russia at the time, Soviet Union, which was only famous for one thing. It had a big nuclear power station, which my dad was working on.

Stewart: Oh gosh. Okay.

Polina: Fun fact. The recent fun fact, I would say, I’d give you two, actually, if I may.

Stewart: Absolutely, yeah.

Polina: From my childhood, I think up until I was age eight or nine, I thought that the bananas’ natural color was more green than yellow because we used to get them in the Soviet Union on the rare occasions and they used to bring them in boxes and they were always green and we would put them under our bed. It took me a while to figure out that actually most bananas are sold when they are yellow, not green.

Stewart: That is a fun fact.

Polina: A more recent fun fact is I’ve actually failed my 32-ton lorry driving license four times in my life. I think I’ve never failed more something, in any exam or qualification.

Stewart: That’s awesome.

Polina: I shouldn’t be driving the lorries.

Stewart: I love that. Just the fact that you have what we call in the US a CDL, commercial driver’s license, is so cool. What captivates you about emerging market fixed income? Because I used to tell my students all the time, “You have got to love what you’re doing to be good at it.” I’ve never seen anybody accept an award that’s like, “I can’t stand this business, but I just happen to be fabulous at it.” You love this stuff and you’re very good at it. What do you think is so captivating about EM fixed income?

Polina: Well, firstly I would say that the reason why I left Russia was because of corruption and because of inability to do or to find a job that I thought would really interest me. That’s also the reason why I’m fascinated about emerging markets because in the job that we do, we have the opportunity to engage with emerging market policymakers and company management to influence them. Despite common belief that in fixed income, if you will, power as investors is relatively limited, I would actually say that often it’s when the access to capital is most difficult, that’s when the issuers are most willing to listen. In emerging markets, many companies and countries struggle to access capital and that’s when we see changes happen. For me, as someone who has emerging market backgrounds and developed market training, I feel that in the job that I do, I actually can make a difference. That’s what fascinates me about this asset class.

Stewart: That is really cool. I think just for clarification, you’re running an $11 billion EM portfolio. I’d love to talk about your career, and your background, and how EM has evolved. You have a number of relationships that I would say wouldn’t have been the first that come to my mind, with policymakers for example. Can you talk a little bit about how your career and the emerging markets have been intertwined and some of the relationships you’ve been able to develop there?

Polina: Well, I guess firstly I would say that I started a job in emerging market by complete coincidence. Actually, my first job was washing dishes in Redlands in California. From there it was a random job of five or six different types, which had nothing to do with investments, which eventually landed me in an investment seat. About 23 years ago, I was offered to start looking at emerging market debt. Having been emerging market equity analyst at the time, my first question was, “Why do you need to analyze the debt? Isn’t that something you put in for the model to balance?” But 20+ years later, I understood the importance of debt analysis and I think what makes this journey special is the fact that just about the time when I started covering emerging market debt was the time when most of the asset class started its growth because it’s a very young asset class. Emerging markets debt really started from Brady Bonds, which was on the back of the Latin American crisis in the mid-eighties.

Then the corporate debt really came into a growth phase after the Asian financial crisis in ’97, ’98. It is an asset class which is just over 20 years old. Like any young, if you will, asset class, as it evolves it also changing quite dramatically in those early stages. If I look back over the last 20 years, the changes that we’ve seen in the monetary policy and the orthodox nature of the monetary policy that we are witnessing today in main emerging market countries, we couldn’t even imagine in the early 2000’s. I feel that when you are on the journey together with the asset class, in a way you form those relationships with the policymakers, with the company management. You create that connection, that, if you will, the dialogue between the two parties, which then helps you understand the asset class much better. That’s what I find particularly exciting about the asset class, that actually we don’t invest without engagement and collectively as a team, we spend about 70% of our time on the ground in emerging markets.

Stewart: Yeah, that’s one of the things I think I’ve been at this for a minute, managing money, as well, and I think that when I hear emerging market fixed income, I have an antiquated view of that market. You mentioned it being young, but at the same time, it’s a substantial size. I learned on an earlier podcast that it is larger than US high yield, for example. Can you talk a little bit about just the market generally and current market conditions before we get into some of the lessons you’ve learned investing through prior crises?

Polina: Actually, Stewart, I’d broaden that definition because when you think about the asset… Within emerging market fixed income, you actually have four sub-asset classes. The whole umbrella is about $23 trillion. It’s meaningfully larger than US yield. But within that you have local currency fixed income, which is both sovereign debt, which is about, I would say just over $10 trillion and corporate debt, which is another seven, eight. Then you have hard currency, mostly dollar-denominated fixed income, which has sovereign debt just under a couple of trillion, and corporate debt, which is in dollars larger than the size of US high yield fixed income. The universe, firstly, is very vast. The second factor, which often is misunderstood is the credit quality of the asset class. If you look at the corporate indices, they are investment grade on average rated.

Even if you look at the sovereign indices, they are double B rated. Investors often become quite skeptical when they hear this because the perception is emerging markets has to be high risk. But there is one misunderstanding: when no one has to invest in your asset class, let’s face it, the allocation to emerging market fixed income is still in single digits as a percentage of clients’ portfolios. Therefore, very few people have to buy emerging market debt. When very few people have to buy it, in order for them to buy it has to offer something more than what the opportunity is today in developed markets. That usually means high quality and wider spread or high yields. That’s why when you think about countries in emerging markets, we have very few countries in sub-Saharan Africa, for example, that issue debt. But the bigger issuer of debt are your more established countries like Mexico, like Indonesia, like Brazil, these are, if you will, better quality countries than some of the riskier stories that investors tend to associate with the term emerging markets.

Stewart: It’s really helpful that you bring up those four subcategories. When we think about BlueBay’s platform, are you investing across those four subcategories? Can you talk a little bit about where you’re focused and anything that you’re avoiding?

Polina: Yes, we do invest across those four subcategories. We also feel that in order to have, if you will, a competitive edge on investing in emerging markets, you have to cover the entire breadth of the asset class because there’s high correlation and causality between different sub-asset classes. Therefore, your credibility in making a call on emerging market corporate debt in dollars without having an understanding what is the local currency framework in this country and the monetary policy is likely to give you a negative asymmetry when it comes to risk/reward. Not only we cover the four main bonds of asset classes effectively, we also cover loans because if you think about emerging market companies, 90% of the companies borrow through banks, not through bond market. We also have a vehicle that invests in emerging market loans, which has five-year lockup terms because loans are not as liquid as bonds.

The other point I would make is unfortunately I learned on my own mistakes and some of the worst investments that I’ve made in my career were not because we didn’t speak the language or we didn’t spend enough time on the ground, it was because there was a loss in translation between different initiatives that policymakers were taking and the impact it would have on the companies. That’s why through that experience we concluded that the only way to invest to assess all those risks is to invest following what we call a mosaic theory approach, where when we spend the time on the ground in emerging markets, we’re agnostic to which sub-asset classes we focus on.

We want to cover the entire, if you will, spectrum both speak to corporate management, speak to policy makers, speak to restructuring lawyers, find local pension funds, collect as much information as possible, and then find what’s the best risk adjusted return in this country. That helps us position best in products that have best idea approach across corporates and sovereign, across local currency and hard currency. That also helps our clients delegate to us the decision on which sub-asset class at which point in time offers the best risk/reward.

Stewart: That’s really helpful and I admire… I obviously do a lot of interviews and I admire when somebody is willing to talk about their mistakes, because I think that investors are the benefits of the asset class, but sometimes things don’t go as planned. Can you talk a little bit about the lessons you’ve learned investing through other crises? Because I think those are going to be instructive to an investor that’s considering either adding to this asset class if they have exposure or making a new allocation.

Polina: Thinking about crises in emerging markets, I would say firstly, often the concept of emerging markets is associated with a high risk asset class, which tends to lead investors in their thinking that the crises are more likely to happen in emerging markets than in developed markets. I think what we forget is often it’s the crises that form your thinking and to some degree if you had a recent crisis experience, you would be a lot better equipped to deal with the next crisis compared to a country or a company that didn’t go through this. I remember in 2008 when we were going through the global financial crisis, I visited every single company that I had in the portfolio and asked their management how they were preparing for this crisis or how they were weathering this crisis. What surprised me were some Brazilian companies that actually responded to me, in particular in one of them in metals and mining industry. They said, “We have more cash than we have debt, and we are not going to spend a dollar of this cash because we want to build even a bigger cash cushion.” I was quite surprised because again, it’s unusual to see a company which has net cash position and still wanting to build more cash. My question was, “What are you fearing?” The answer was from the CFO at the time that in the mid-eighties they went through the experience where they could not get a single credit line from a single bank in the world. He said, “I swore to myself that I’ll never get through this experience again.” It’s interesting how sometimes actually companies or countries can be better prepared.

This crisis that we’re going through right now is a classic example of that. If you think about the biggest problems that we are facing today is the problem of inflation. This is a very typical problem for a majority of emerging markets who in some cases and in my personal experience, lived with hyperinflation environment. That’s why if you look at most of emerging market countries, they started hiking rates almost two years before the Fed had to hike, because they don’t have a safety net. They know how dangerous high inflation is and how limited the policy toolkit can be once you went into the double-digit inflation numbers. They don’t want to take any chances. That’s why when we look at today’s inflation numbers in emerging markets, they’ve been coming down for over a year.

Stewart: That’s great. Can we talk a little bit about liquidity? Insurance companies, particularly PNC companies, have liquidity needs from time to time and it’s something that, whenever I interview someone like you, I’ve always got my CIO hat on. I’m wondering about current liquidity conditions and what you anticipate as we go forward here.

Polina: I guess when I think about liquidity, there are three angles that are worth highlighting when it comes to assessing your liquidity. The first one is just the issuer size. Now, naturally the more bonds you have outstanding for a single issuer, the better the liquidity will be. I think that’s where emerging markets sovereign debt compared to corporate debt is much more liquid. If you think about the average size of the issuer in the sovereign index, given that the index has only what, 73, 74 countries, you tend to have even in high yield countries that have multi-billion tranches of debt outstanding and that improves liquidity. Now, I would say that… Now, comparing liquidity to an emerging market, fixed income to develop market fixed income, I would say that in the corporates liquidity is very similar to the liquidity in the corporates in developed markets. In sovereign it is better because of the issue size.

The second aspect worth highlighting is event risk. Naturally, liquidity does dry up when there are headline risk and that’s normal for all markets. Given that we tend to have a lot more headlines in emerging markets, often on headlines you might actually see liquidity drying up, but this is a short-term phenomenon.

Thirdly is flows. If you think about emerging market fixed income, last year was the first year in my experience, over the last 20 years where we’ve seen meaningful outflows. We’ve had over 90 billion outflows in out of emerging market portfolios. Generally every year we see between 20 to 80 billion inflows in the asset class. Of course, when you see a one-way outflow, then liquidity also becomes challenged, the same way it becomes challenged on their big inflows. Overall, I would say that those are the three aspects that I would highlight when we think about liquidity in EM.

But I also think it is a misconception to say that EM fixed income is less liquid than developed markets, mostly because in its holistic sense, liquidity is driven by disparate nature buyers and sellers, who have different valuation matrices. In emerging markets because the dedicated players, as we started this conversation with, we were talking about how few dedicated players you have in emerging markets. It’s one of the asset classes with the most disparate group of investors from local pension funds, to private individuals, to international sovereign wealth funds. That’s what forms the basis for liquidity because those disparate players have disparate valuation metrics. That’s where I would say that I wouldn’t put liquidity as one of the core concerns when investing in emerging market fixed income.

Stewart: Thank you, that’s really helpful. Let’s turn to China just for a second. Is China EM or is it a developed market? What’s your thoughts longer term on the role of China?

Polina: I’m glad you brought this up, Stewart, in terms of definition of emerging markets, because even that point is slightly perhaps misleading. When emerging market corporate indices, for example, were formed, they defined emerging markets based on geographies. In other words, they said, “All the countries in the world that are not in Western Europe, North America, Australia or Japan will become emerging markets.” That’s why you have Singapore is being in our index, as well as Chile, and other countries that are like Hong Kong that are a lot more developed, if you will, than emerging market tag would suggest. Now, in that context, China firmly falls in emerging market camp. Now, if you think about the importance of China, it’s hard to underestimate, given it’s the second-largest economy in the world. Actually, when it comes to its focus and its role as a consumer of commodities, as a provider of liquidity to other emerging markets, as an exporter of goods, it’s probably the largest economy in the world.

Now, it does matter what happens in China. With that said, I feel that market often misinterprets the decision of policymakers in China because they try to apply western type of thinking, if you will, with the focus on total returns to a Chinese mindset. Often, those objectives are just not aligned. I was in China just a week ago, and when you think about the real estate sector in China, which has gone through a lot of turbulence to say the least, over the last two to three years. With a western hat on to some degree, you can look at the situation and say, “Well, China has the lowest interest rates in the world, maybe excluding Japan. They have tied fiscal, they have room to ease both on the fiscal and on the monetary side. Why are they not injecting more liquidities to support the real estate sector? It’s simple.” Yes, all of those points are correct. However, they contradict the bigger objective of Chinese policymakers. The bigger objective that they’ve been very clear for the last two to three years is to make housing affordable. In order to make housing affordable, you actually don’t want prices to go higher. You want to slow down the pace of this price appreciation, and that means perhaps it’s not as wise to release more liquidity in the sector so that the real estate developers try to get their margins higher. But this development in itself wouldn’t necessarily achieve the policy goal. I always feel that firstly the misperception about China is that you don’t know what’s happening. I actually think they’re incredibly clear on the direction of travel. They write the memos and they follow their advice. It’s very simple to understand the policy framework. What is the challenge is to translate what this policy framework means for investor returns. At this juncture, my personal view is that the policy framework is not necessarily aligned with investors’ expectation to deliver higher returns from Chinese investments.

Stewart: That’s interesting. You mentioned when you outlined the four subcategories of EM fixed income, and you mentioned earlier hard currency or US dollar-denominated fixed income instruments, there’s efforts underway to try to… I don’t know if it undermines is the right word, but the US dollar as the world’s reserve currency potentially efforts to move to the yuan or something else. What do you think the next few years bring for the US dollar as the reserve currency? Do you think that there’s momentum to shift away from it? What’s your view there?

Polina: Well, looking at history, which often is helpful, I would say last time around it took the World War to create the dollar as a reserve currency or to put it in place. Firstly, I think that the journey to create a new reserve currency, which would be on parallel with the dollar is a long-term venture. Secondly, I think that already today we are starting to see signs of increased usage of alternative currencies. I think the most interesting space to watch at this point in time is commodities. The most commodities used to trade only in dollars, but if you look at today a commodity flows 20% already are settled not in dollars. That doesn’t only include the renminbi, but it also includes the Brazilian real, obviously it includes Russian rubles; it includes the currencies in large emerging market economies. To me, that’s an interesting trend to follow and I think that trend is only likely to increase.

With that said, the commodity flow forms a very small part of the overall currency flows and financial flows are still very much dominated in dollars. I don’t see dollar disappearing as a reserve currency, but I can see a structural trend to strengthen other emerging market currencies. That’s where for the first time in 12 years, we feel that, actually, the local currency debt in emerging markets that has had a horrible decade since 2010 is likely to deliver better total returns than top currency debt given the strength of the currencies and higher interest rates given the orthodox monetary policy mix, which led to multiple hikes over the last couple of years.

Stewart: Very interesting. As we wrap here, Polina, what’s the takeaway that you want our audience, if you could have one factoid or one takeaway that you want folks to remember about emerging market fixed income, what would that be?

Polina: At the risk of saying a cliche, I would say that when we look at today’s world, we have to acknowledge that there is a very high level of uncertainty when it comes to direction of global growth, when it comes to direction of global inflation and the response the policymakers and the company management would have to those. When uncertainty is high, diversification really matters because if I would’ve told you the events that happened last year and asked you which fixed income asset class do you think would’ve been the best performing, I bet out of a hundred investors, not one would say emerging market effects, but it was. I feel that we are in the environment where, firstly, diversification matters.

Secondly, you’ve seen much bigger dislocation in emerging market valuations and particularly in the sovereign debt, and because those countries didn’t have the safety net of developed markets. But that means that in some instances it’s already time to invest because the path is clearer for recovery for some of those emerging market countries.

Thirdly, when you think about the complexity of the decision-making in today’s environment, I feel that looking at corporate credits for example, it’s difficult to make a conviction call on what would drive the corporate returns because in a low growth world, those companies that are doing very well might be punished by the government and ask to share some of their profits. Those that are not doing well at all might increase the default numbers. In emerging markets, and particularly in the sovereign sub-asset class, we feel that you’ve removed a number of those uncertainties because you’ve had a tailwind from monetary policy, you’ve had a tailwind from commodity prices. To some degree, investing in the sovereign debt from here is actually a very simple decision compared to the number of risk factors you have to take on the corporate side, both in emerging markets and developed world. I know I actually gave you three and you asked me for one.

Stewart: That’s okay.

Polina: But to sum it up, I feel that in emerging market investing, what’s comfortable is really profitable. If you want to generate better risk adjusted returns, you have to look beyond the FT headlines and the fundamentals, which to me speak for themselves in today’s world.

Stewart: That’s fantastic. I’ve got one fun question out the door, actually two. You can choose either, or some of our guests have chosen to answer both. Here we go. Best piece of advice you’ve ever gotten or who would you most like to have lunch with, alive or dead?

Polina: I’ll go for both.

Stewart: I love it. I love it when they choose both. That’s great.

Polina: Best piece of advice was probably from my ex-colleague who said that work ethics and emotional intelligence is a lot more valuable in an employee than an IQ, and I would wholeheartedly subscribe by that fact. They question on whom I would have dinner with, dead or alive was actually asked of me by our CEO, and my answer was Nelson Mandela.

Stewart: Oh, that’s a great one. Yeah. Very cool. I like it. I’ve learned a lot today. Thank you very much for taking the time and thanks for being on.

Polina: It’s an absolute pleasure. Thank you so much, Stewart.

Stewart: We’ve been joined today by Polina Kurdyavko, who is the head of EM debt and BlueBay senior portfolio manager at RBC Global Asset Management. Thanks for being on. Thanks for listening. If you like what we’re doing, please rate us, review us, and tell your friends at Apple Podcast, Spotify or wherever you get your podcast content. My name’s Stewart Foley, and this is the podcast.

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RBC Global Asset Management
RBC Global Asset Management

RBC Global Asset Management (RBC GAM) is the asset management division of Royal Bank of Canada (RBC), the 5th largest bank in North America and 8th largest in the world based on market capitalization. As an asset manager with global scope and industry-leading management capabilities, our purpose is to provide clients an unrivalled experience of investment and service excellence. With professionals in North America, Europe and Asia, RBC GAM provides a comprehensive range of investment solutions and services to both individual and institutional investors. Our global scope, knowledgeable investment professionals and commitment to excellence drive traditional and leading-edge solutions that address and evolve with our clients' investment objectives. With more than $412 billion in assets as of 3.31.23, RBC GAM's 18 investment teams composed of more than 380 investment professionals are committed to providing clients around the globe with appropriate investment solutions.

Andrew Tewksbury
Director, Institutional Sales
Office – 203-241-1005

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