‘Survival’ and ‘Revival’ – the keys to portfolio management in a crisis
By Samy Muaddi, portfolio manager of the T. Rowe Price Emerging Markets Corporate Bond Fund
Given the heightened volatility environment – with a series of multi-sigma in credit spreads spikes since the end of February – the decisions we take over the next three months are likely to disproportionately influence our returns for the next three years.
This is my sixth EM credit cycle – after 2008, 2011, 2013, 2015 and 2018. For the EM community, these cycles seemingly happen every two years – either in specific countries or, as now, for the entire market. However, the good news is this only the second worst cycle of my career. Recent volatility spikes are reminiscent of the global financial crisis, but the difference is I am not doubting the fabric of financial architecture and counterparty stability today.
Nonetheless, we have a plan. It has two coinciding steps. The first is ‘survival’ – which is preserving the capital of our clients in the drawdown. Second, it is ‘revival’ – positioning our portfolio for the rebound. If we can avoid defaults, the survival, our bonds will still pay semi-annual coupons and pull to par by maturity, the revival.
Prior positioning was pivotal
In an unforeseen crisis, the survival phase does partly depend on your prior positioning. Given the precipitous drop in market liquidity, many investors are being forced to live with choices made before the crisis. In advance of the crisis, we had a number of factors supporting survival.
Firstly, we rotated the portfolio towards Asian credit in January and February, which has outperformed both developed and emerging market credit in both investment grade and high yield markets. Asia was earlier to enter the health crisis and benefits from a stronger domestic base of investors versus the rest of EM.
As for energy, we entered the OPEC+ breakdown with a significant underweight to energy – our lowest net weight to oil and gas since inception. In addition, we entered mid-February with a below-average risk position, while our security selection, on balance, has been strong. Importantly, we may remain in the survival phase for weeks, if not months.
Our most attractive portfolio
Looking forward, the revival theme is about adding risk into what we view as historically attractive valuations. In the eight years we have offered a dedicated EM credit mandate, this is arguably the most attractive portfolio we have ever managed. EM credit now has an average BB rating, a near 7% yield, and a spread of more than 600 basis points.
It is important to highlight most bonds are trading down due to forced sales in a liquidity vacuum. Taking the other side of these trades presents an outstanding long-term investment opportunity. We can and should be a liquidity provider into these dislocations. We will step into the market and support our existing positions with additional capital.
Importantly, we are staying underweight the most negatively convex parts of market, which includes energy, as well as a select number of vulnerable EM countries – such as Sri Lanka, Turkey, South Africa and Mexico. This allows us to fund risk elsewhere. The most efficient portfolio construction today is to be more overweight the middle of the risk distribution – in BBB-to-BB rated bonds yielding 5%-10% – instead of bar-belling the tails of high quality and distressed credit.
The rally may be as sharp
Survival and revival are coinciding steps, but the former is most important. If we can preserve capital, generating attractive returns on the upside will be less challenging. Nothing we have seen in the monetary, fiscal, political or public health reaction functions convinces us volatility has been structurally dampened.
The market’s bottoming will be dictated by a combination of the central bank response mechanism and an improvement in the rate of change of the infection curve in large economies. Given our starting point on rates, fiscal policy may have to do more of the heavy lifting, but to what extent this materialises remains to be seen.
If history is any guide, and without having to call the bottom, we see the potential for double digit excess returns over the next 12 months for EM credit. This is the second worst drawdown in the history of the asset class and as violent as the sell-off has been, it is possible the rally will be just as sharp.