The importance and size of the EM hard-currency corporate bond market has grown considerably over the past two decades, from USD 50 billion in 2001 to USD 1.8 trillion in 2018. As a result, these assets now comprise a significant portion of global credit benchmarks. Over time, and given the widening opportunity set, our factor investing research has expanded into this space.
In one of our recent studies1, we analyzed whether generic credit factors known from developed markets also work in emerging markets. We found that low risk, value, momentum and size, as well as the combined multi-factor portfolio, delivered significantly higher risk-adjusted returns compared with passively investing in the EM credit market index.
Figure 1 | Annualized Sharpe ratios (2001-2018)
Source: Robeco, Bloomberg Barclays. This figure shows the Sharpe ratios of the size, low-risk, value, momentum and multi-factor portfolios for emerging markets hard currency corporate bonds over the 2001-2018 sample period. We use excess returns over duration-matched US Treasuries, German Bunds, and UK Gilts for US dollar, euro, and sterling denominated bonds, respectively. If an issuer has more than a 2% market value-weight in the index in a month, the market values of its bonds are proportionally scaled down to cap the issuer weight at 2%.
We also investigated whether the higher risk-adjusted returns had been achieved despite or because of exposure to country-specific risks. Investors in EM credits are highly exposed to these risks, as the numerous credit events and crises in emerging markets over the past few decades have demonstrated. These risks tend to have a material impact on a country’s fundamentals, as well as the creditworthiness of corporate issuers from the country.
The efficacy of factors in EM credits is predominantly driven by bond and issuer selection
We observed that factor portfolios corrected for country risk also delivered higher risk-adjusted returns than the market, albeit slightly lower than the factor portfolios allowing for substantial country exposures. Therefore, we concluded that the efficacy of factors in EM credits is predominantly driven by bond and issuer selection, and to a much lesser extent by country allocation.
Figure 2 | Annualized Sharpe ratios (2001-2018)
Source: Robeco, Bloomberg Barclays. This figure shows the Sharpe ratios of the country-neutral size, low-risk, value, momentum, and multi-factor portfolios for emerging markets hard currency corporate bonds over the 2001-2018 sample period. The country-neutral portfolios are formed by first selecting the 20% best bonds per country and then market value-weighting all selected bonds to form the final factor portfolio. We use excess returns over duration-matched US Treasuries, German Bunds, and UK Gilts for US dollar, euro, and sterling denominated bonds, respectively. If an issuer has more than a 2% market value-weight in the index in a month, the market values of its bonds are proportionally scaled down to cap the issuer weight at 2%.
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The results of our study provide a good theoretical foundation for the use of credit factors in emerging markets. However, while academic factor definitions are useful to document factor premia, in practice they can expose investors to unnecessary risks.
We therefore also tested whether our enhanced factor definitions work in emerging markets. These definitions take into account additional types of information, such as accounting and equity market data, allowing for a more complete risk assessment, while limiting exposure to unrewarded risks. We found that our enhanced factor definitions led to better risk-adjusted returns compared with generic factors.
In addition to using our enhanced factor definitions, we also incorporate fundamental company research in our live strategies to complement our quantitative risk assessments. Indeed, not all risks are quantifiable. Political, geopolitical and sustainability risks can have a material impact on EM credit returns. Thus, when experienced members of our fundamental credit analyst team identify risks that are beyond the scope of our model, we remove the corresponding credits from the list of investable bonds.
The results of our study provide a good theoretical foundation for the use of credit factors in emerging markets
Moreover, we integrate liquidity management into our portfolio construction process. In our live strategies, we use real-time liquidity information, collated from multiple trading and pre-trade transparency platforms, to estimate a tradeable amount for each top-ranked bond, as well as a target price. This typically results in cost-efficient implementation that provides maximum exposure to factors.
Following years of extensive research in EM credits, we decided to include these bonds in the investment universes of our Global Multi-Factor Credits, Global Multi-Factor High Yield and Global Multi-Factor Bonds strategies as of February 2021. The aim is to benefit from alpha opportunities that exist in this segment, and to allow the strategies to close their structural underweight allocations to the asset class, as they are benchmarked against global indices which contain EM credit constituents.
1See: Dekker, L., Houweling, P., and Muskens, F., June 2021, “Factor investing in emerging market credits”, Journal of Index Investing.