Welcome to Soundbites, weekly insights on market trends and investment strategies, brought you by Investment Executive and powered by Canada Life. For today’s Soundbites, we speak with Alberto Boquin, senior research analyst with Brandywine Global Investment Management, as we consider opportunities and risks in emerging-market fixed income. We asked about currency risk and post-Covid recoveries, and we started by asking what regions he’s particularly interested in.

Alberto Boquin (AB): So, there’s been two drivers. One is commodity exposure. Anyone who exports commodities has done well. Brazil and South Africa stand out. And on the flip side of that, anyone who is a commodity importer — like a Turkey or an India — is definitely more challenged from a fundamental standpoint. The other part that’s been interesting has been the wind-down of the post-Covid policies. By and large, you had central banks cut rates to historical lows, you had a lot of fiscal stimulus coming out, and with the bounce back that we had, people started winding that back. The ones that were quicker to wind that back are in a better position right now. I would highlight the likes of a Brazil or a Chile that started raising rates mid- to late-last year and are now a little bit more ahead of the game

High-yield corporate debt.

AB: In the era of Q.E., post 2010 or so, there were a lot of new issuers that came to market because conditions were very attractive. And those bonds are coming due, and people are reconsidering whether these are going concerns. A lot of issues in the single-B and below space are simply not going to be able to refinance, given ongoing fundamentals, the fact that we’re looking at a recession over the next 12 to 18 months, and defaults are going to rise in that space. Some of the better-quality corporates, especially the ones that have pricing power in this environment, are going to be better off. They’re finally attractive from a risk-reward perspective.

Sovereign debt

AB: Similar to what’s happening in corporates, there are sovereigns that are under duress and are probably going to default in coming months. A lot of the stuff in the single-B space, triple-C stuff is looking pretty challenging. And, again, it was countries that got a lot of financing when there was an ample liquidity backdrop, and now the markets are reconsidering what to do with the likes of a Ghana or a Sri Lanka, for example. But if you go a little bit up in quality, and you look at triple-B, double-B kind of credits, they’re in a much better position. Valuations are a lot more attractive. A lot of Brazilian sovereign debt is interesting. South African sovereign debt is interesting as well. You can take a gamble and look at some of the oil exporters, like a Colombia or a Mexico, and those could be interesting as well.

About currency risk.

AB: So, starting points matter, and valuations generally suggest that the dollar is expensive. But when we do get a U.S. recession and the Fed does cut rates, there’s probably going to be a time for U.S. dollar underperformance. My best guess is you get a U.S. recession in mid- to late-2023 and that’s when the dollar starts to underperform. When it comes to specific E.M. currencies, what is interesting is that, because of the high inflation that the world has faced, you’ve had developed markets take rates to 2, 3, 4%. A lot of EMs have had to take their interest rates to 10% or higher. And so, even if you think a currency is going to move against you, if you have a 10% cushion, the carry-adjusted return looks pretty attractive.

About liquidity risk.

AB: It’s something that you have to go in knowing what you’re getting. So, hard-currency bonds are particularly tricky. You’ll have issuances in the primary market of a billion dollars plus, and then, when you actually try to transact the specific bond, a $10 million ticket is quite big. And so that’s a market that’s always very challenging, in terms of flipping your positions. Local bond markets will move around, you know, 15 [or] 20 basis points in a day. But there’s a very good local buyer base when it comes to local pension funds and local bank treasuries. So, liquidity is pretty easy there. It’s just the kind of world where U.S. treasury liquidity is not what it used to be, right? So, it kind of applies to every asset class.

And, finally, what’s the bottom line on finding returns in emerging-market fixed income?

AB: I would say in terms of valuations, it’s the most attractive investment opportunity that I’ve seen in 10 years. You just need the fundamentals to follow through. So, in the local bond space, you need peak inflation to actually happen — which could be as soon as Q3 in some of these markets. And in the hard-currency space, you need credit fundamentals to hold up a bit better than expected. But it’s still very much two markets with very high dispersions. So, you have to be able to pick your names, rather than make index bets.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Alberta Boquin of Brandywine Global Investment Management. Join us every Wednesday at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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