GMO Commentary: No Stone Unturned

Executive Summary

As an alpha manager with a global opportunity set, GMO is well equipped to create variations across the spectrum from single-benchmark, through blended-benchmark, and right across to total return solutions. Our skills are deep in sovereign and quasi-sovereign credit (in hard and local currency); as well as in managing local currency and interest rate exposures. With U.S. interest rates rising and the U.S. dollar (USD) continuing to pose challenges to holding long-only emerging markets currency (EMFX) exposure, now could be the appropriate time to consider a new approach to emerging debt investment. A total return solution can eliminate systemic exposure to U.S. duration and EMFX, while a blended solution can be tailored to capture only the amount of those beta exposures that is considered desirable. In terms of expected return, a typical target would be 150-200 bps of net alpha relative to standard benchmarks, including blended ones, or cash + 7-9% for total return solutions.

Introduction

We strongly believe that the traditional benchmark-led approach to investing in emerging market debt can be far from optimal. There are two major flaws in being overly wedded to an off-the-shelf benchmark:

1. There are embedded characteristics, or betas, that may not necessarily be desirable. In particular, there is significant USD duration exposure associated with a hard currency strategy ¹ , typically managed relative to the EMBIG-D, ² while EMFX exposure is a major component of a local currency strategy, typically managed relative to the GBI-EMGD. ³ It is often the case that an investor already has plenty of USD duration from other bond portfolios and EMFX exposure from emerging market equities, yet simply accepts these characteristics as part of an emerging debt investment because they are embedded in the benchmark. (A blended benchmark is somewhere “in between” from a beta standpoint, with lower durations than EMBIG-D, and EMFX exposure determined by the extent of GBI-EMGD’s presence in the blended benchmark.)
2. If a manager’s opportunity set is constrained by their benchmark, potential alpha opportunities may be de-emphasized, or even ignored completely. For example, there can be limits on the amount of “off benchmark” holdings and exposures that a manager may take relative to their EMBIG-D, GBI-EMGD, or CEMBIB-D ⁴ benchmark, regardless of how similar such exposures may be in practice relative to his stated benchmark. In theory, blended benchmarks relax this constraint, expanding alpha opportunities. ⁵

We are increasingly having conversations with clients that are seeking to unlock the exciting return opportunities in emerging debt while being much more discerning about embedded betas. A single benchmark, or indeed a blend of benchmarks, can be determined to allow for whatever USD duration and EMFX exposure best suits the investor’s overall objective. Lately, with more emerging countries entering debt distress and/or default, the “quality” axis is also a topic of interest, with some clients preferring the stability of higher-quality credits, and others interested in leveraging our considerable skill in sovereign debt workouts among distressed/defaulted issuers (some of which are “frontier” markets). To us, these are the “big” asset allocation levers, although blended benchmarks are not the only way to achieve them given how trivial it is to target duration, USD/EMFX exposure, and/or quality in any setting. An obvious extension is to remove the beta associated with emerging debt benchmarks completely, and freely use the full combination of alpha sources to target a total return over cash. Indeed, whatever overarching objective is set, the ability to use all alpha sources coupled with a liberal approach to tracking error should ensure the best outcome. We already use this approach in the management of our existing long-only strategies.

As a manager with nearly 30 years managing a global emerging debt opportunity set, GMO is very well equipped to create variations across the spectrum from single-benchmark, through blended-benchmark, and right across to total return solutions. Our skills are deep in sovereign and quasi-sovereign credit (in hard and local currency); as well as in managing local currency and interest rate exposures. In terms of expected return, a typical target would be 150-200 bps of net alpha relative to standard benchmarks, including blended ones, or cash + 7-9% for total return solutions.

Total Return – Arriving at Cash + 7-9%

GMO has a long and successful track record in alpha generation, ranking top eVestment quartile in each of its hard and local currency strategies over all relevant time periods as of 12/31/2021. A distinguishing feature of GMO’s approach is our alpha emphasis on bottom-up (“in country”) instrument selection over top-down exposures to countries, currencies, or duration, as well as a strong preference for relative value over timing (although one exception to this is our view of the credit spreads versus expected defaults). This alpha approach makes us well suited for total return applications.

In order to target a return of cash + 7-9%, we use a mix of credit (typically partially hedged), EMFX, and rates.

GMO is known for its extensive experience managing all aspects of sovereign credit, including performing, stressed, distressed, and defaulted issues. We are pioneers in this space, and regularly recognized as such. Within sovereign credit, the universe is broad both by country and by currency, including hard and the local currency of each country. ⁶ More importantly, though, the universe is also broad by instrument type, including bonds, loans, credit derivatives, and project finance, among others.

Similarly, for quasi-sovereign investments, a dedicated team scours the entire investment universe for opportunities to add alpha relative to sovereign-only exposures. Under our broadest definition of quasi sovereigns, our universe covers more than half of the market cap of the CEMBIB-D, as state-owned entities feature prominently in emerging markets. ⁷ Of the remaining “pure corporates” in the CEMBIB-D index, few have offered alpha potential for our portfolios, and some have proved interesting only after they have defaulted out of CEMBIB-D. ⁸ In all cases, we carefully examine the documentation to understand our rights in adverse outcomes.

Of course, this return generated from credit spreads is a combination of alpha and beta – the credit spreads are, after all, embedded in benchmarks. It is worth noting that this EM credit spread beta is unique to – and possibly even the core essence of – the asset class, unlike the beta exposure to USD duration or EMFX that are also captured by benchmark. Given the nature of the issuers, hedging the credit risk can be non-trivial and mostly unadvisable. In most time periods credit spreads exceed expected losses, and our Quarterly Emerging Market Debt Update keeps track of this time-varying “credit cushion.” Thus, any hedging of credit risk focuses on limiting permanent losses from defaults rather than limiting mark-to-market volatility.

The shift from long-only benchmark-relative investing to total return, then, is two-fold: 1) reducing the USD duration toward zero and 2) translating over/underweight benchmark-relative positions to leveraged long/short ones. Because we do partially hedge credit risk, and also because the long/short nature offers some protection against systemic credit risk, one could typically expect a residual credit beta to EMBIG-D in the region 0.2-0.8 depending on the view of the risk and reward trade-off.

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