Diversifying in EM: The quest for yields while curbing volatility
The quest for satisfactory yields from bond market investments has been a challenging task for a while now and the current outlook does not indicate significant changes in the short term. Therefore, to address the low yields offered by interest rates from developed countries, it is necessary to broaden the investment horizons, for example by diversifying the investments into emerging markets. The coupons paid by emerging market bonds may be an important alternative, but you must also be willing to accept periods of price volatility with these securities. The strategy adopted by Epsilon Fund Emerging Bond Total Return is an opportunity to invest in these markets while curbing volatility.
This strategy is not correlated to the market and adopts a defensive approach aimed at preserving capital over a 12-month period, curbing volatility and drawdown. The objective of EF Emerging Bond Total Return is to achieve an average annual return, gross of management fees, exceeding by 1.30% the performance of the Barclays Euro Treasury Bills Index over a time horizon of 36 months.
TWO PERFORMANCE DRIVERS
The strategy has two performance drivers. A buy & hold portfolio consisting of short-term bonds (up to 36 months) in hard currency that are held to maturity. These bonds are government and corporate issues whose exchange rate risk is systematically hedged. It is supported by a tactical portfolio whose aim is to explore opportunities in emerging markets and at the same time protect the investments during downturns. It consists of medium and long-term securities in hard currency, local debt securities and currency bets.
Over the years we have observed that the tactical component generates approximately one-third of the subfund’s overall performance. The remaining two-thirds comes from the carry trade generated by the buy & hold component. Given the performance achieved, an “enhanced” version was created that takes advantage of these tactics. Given its nature, this sub-fund has a higher risk rating compared to the previous Epsilon Fund Emerging Bond Total Return sub-fund and for this reason it aims to achieve higher returns, with a target equal to the Barclays Euro Treasury Bills Index + 2,00%.
OPERATING IN THE WORLD OF EMERGING COUNTRIES
Emerging Countries are extremely heterogeneous, with risk and opportunity characteristics that are equally diverse. Investing in these countries implies geographic diversification, diversification by rating, by growth model or simply by per capita wealth, which represent a unique aspect of this investment class. With regard to the management of EF Emerging Bond Total Return, the country selection process begins with an internally developed model that classifies the emerging economies based on macroeconomic and political indicators. The worst ten countries are excluded from the investment scope. In the second phase, only those countries with bonds maturing in less than three years are selected from the “eligible” countries. This is how the basket of approximately 30 countries that make up the investment scope is constructed.
Subsequently, the portfolio is constructed giving priority to sovereign and semi-sovereign issues and applying the principles of diversification with regard to both geography and creditworthiness. Regarding the latter, particular attention is given to making sure that the portfolio is rated as close as possible to Investment Grade. At the moment, approximately 60% of the instruments in the portfolio have a rating between BB and BBB.
HARD CURRENCY VS LOCAL CURRENCY
The sub-fund primarily invests in securities denominated in hard currencies (currently about 90%), while exposure to local debt securities is residual. The strategy aims to collect coupons paid by the emerging bonds, avoiding duration and exchange rate risk, while credit risk – though present – is mitigated by utterly excluding the weakest countries. Indeed, since the initial country classification model is based on macroeconomic and political aggregates, sovereign and semi-sovereign issuers are favoured in the selection process.
Currently, the main challenge of the portfolio is the exposure to a basket of emerging market currencies. In moderately volatile financial markets, certain emerging market currencies still provide high nominal yields and are solid carry trade opportunities. Local debt securities and all bonds with maturities exceeding three years, currently around 20% of the sub-fund’s total assets, are part of the tactical portfolio.
Epsilon Fund Emerging Bond Total Return is a sub-fund organised under the laws of Luxembourg, established by Eurizon Capital S.A., and managed by Epsilon SGR. The subfund has a risk/return profile of 3 on a scale from 1 to 7. No guarantee is provided to investors with regard to the sub-fund achieving its objective.