By moving our USD emerging debt strategy benchmark to the diversified (issuer-capped) version of J.P. Morgan’s EMBIG benchmark, we will limit our exposure to the ballooning issuance of low-return-potential, opaque countries. Our objective is to retain the “high dividend sovereign equity” nature of this asset class for our investors rather than accept low returns in lending to these “high quality” countries who then compete with us in lending to traditional emerging country borrowers offering higher return potential.
Since inception, GMO has positioned the EM external debt asset class as “high dividend sovereign equity.” In other words, EMD is a risky asset class and ought to compete with other risky assets held in one’s asset allocation portfolio. Indeed, over the last 25+ years, the high-risk, high-reward nature of the asset class has delivered handsomely (see Exhibit 1). EMD being defined by a country’s income status rather than its credit rating has meant that, over time, the market-cap weighted EMBIG has drifted up and down around the typical investment-grade/sub-investment grade divide.
EXHIBIT 1: EMERGING DEBT AS “HIGH DIVIDEND SOVEREIGN EQUITY”
As of 12/31/19 | Source: GMO, MSCI, J.P. Morgan. Emerging Equities benchmark is MSCI-EM (USD). Emerging Debt benchmark is EMBIG and its successors (EMBI, EMBI+) over time.
More recently, with the rise of China and last year’s inclusion of higher-income Gulf Cooperation Council (GCC) countries into the benchmark (see Exhibit 2), the ratings composition has drifted upward, with 24% of EMBIG now A/AA-rated. From an alpha perspective, such issuers comprise some of our largest underweights given: 1) pronounced relative uncertainty about their published fiscal statistics in the context of low spreads; and 2) high indirect portfolio exposure to these countries stemming from exposures to other, higher-yielding EM countries. Therefore, we have decided to move to the “Diversified” version of the EMBIG benchmark, which caps larger issuers, thus bringing the benchmark more in line with our strategy.
EXHIBIT 2: "SUPER SENIOR" (HIGH QUALITY) CREDITS ARE JUMPING INTO THE BENCHMARK...