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Can you walk us through your background? How did you come to the Vanguard Fixed Income Group and what roles have you held during your career?
I started in the asset management industry at one of our competitors based in New York City. My first role was in the risk management group, where I focused on monitoring risk for fixed income alternative products, which included a large hedge fund. That background gave me a unique perspective on both risk management and relative value, which hedge funds monetize through levered long-short positions. After a few years in risk management, I moved to their emerging markets team, where I traded bonds and managed strategies across mutual funds, hedge funds, and separate accounts.
I joined Vanguard in 2013 to build out the emerging markets team that was supporting alpha generation in our active bond funds. Today we have an industry-leading EM team that manages a top-performing EM strategy; the team includes crew in London and our Pennsylvania headquarters.1 I also work closely with other senior portfolio managers in managing the strategy for our entire active taxable fund lineup, with a special focus on our broader portfolios that have more aggressive alpha targets.
In general, what makes emerging markets debt stand out from other parts of the credit market?
The part of the emerging markets asset class most comparable to other types of credit is external sovereign debt, which is borrowing by countries in “hard currencies” such as the U.S. dollar or the euro. Some issuers are rated as investment grade, while others are rated lower.
Emerging markets debt is unique in several ways. These differences make the asset class more resilient and provide opportunities for skilled active managers to add alpha.
First, unlike U.S. investment-grade credit and U.S. high-yield credit, EM debt offers both wide spreads (like U.S. high yield) and longer durations (like U.S. investment grade). With wider spreads and longer durations, price returns can be large: Owning the right credits can be very rewarding as spreads move substantially tighter.
The second major difference is that countries tend to be larger than companies. A country will often have many bonds or other credit investments for investors to choose from, and this wide selection creates opportunities for relative value.
Third, emerging markets bonds can be more defensive than similarly rated corporate bonds because countries have access to all sorts of emergency and nonemergency financing. This financing may come from multilateral institutions like the International Monetary Fund or from other friendly countries. Additionally, those longer durations mean that adverse spread movements can be partially offset by falling global interest rates during periods of market stress.
What secular changes are occurring in emerging markets?
The biggest change we’ve seen in the last 10 to 15 years has been the increase in diversification within the asset class. There are many more sovereign debt issuers today than when I started in the business in the early 2000s. We’ve seen new issuers come from both the riskier and the safer corners of the market. On the riskier side, we now have debt from fast-growing, but still very poor, countries in sub-Saharan Africa. Those bonds are often B-rated. On the safer side, we have debt from wealthy oil- or natural gas-exporting countries in the Middle East; these countries are using the market to fund their economies’ long-term shift away from hydrocarbons. Those bonds are often A- or AA-rated.
These changes can reduce the volatility of EM portfolios because exposure to a greater number of issues can decrease the impact of problems from a single credit. For active managers, having more issuers to choose from also increases the opportunity for credit selection.
The easing of monetary policy—or the anticipation of it—is a key driver across most bond markets right now. How does this impact emerging markets?
We talked earlier about how EM debt issues tend to have longer durations. Some bonds are issued for 30 years or longer. If interest rates were to come down, returns for EM debt would be supported both directly and indirectly. Directly, these bonds are denominated in U.S. dollars, so they’ll benefit as U.S. Treasury yields drop. Indirectly, an easier monetary policy mix supports global growth, and strong economic performance coupled with lowered borrowing costs make countries’ debts easier to afford, which would drive spreads tighter.
Even so, lower Treasury yields are not guaranteed to be good for EM debt. Easing in response to falling global growth or even a recession would act as a headwind to all riskier assets. In that case, EM debt spreads would likely widen, which would, in turn, offset much of the benefit of falling U.S. yields.
How should investors use an emerging markets fund in the context of a total portfolio?
Vanguard Emerging Markets Bond Fund invests primarily in external (U.S. dollar-denominated) sovereign debt. As a result, investors should view it as part of their credit portfolio, keeping in mind that the credit risk of EM debt is somewhere between U.S. investment grade and U.S. high yield. EM debt can be used to increase the credit risk of a core bond portfolio, creating opportunity for higher returns and income. For investors with modest risk tolerance who are not limited to an investment-grade credit rating, EM’s history of strong risk-adjusted returns and the potential for additional alpha would argue for an impactful allocation. When sizing the allocation, investors should keep in mind that, even though EM has become more diversified over time, EM bond funds still carry considerable concentration risk in certain EM countries. A country allocation of 5% or more in a dedicated EM bond fund is not unusual.
Not all emerging markets debt strategies are the same. What’s your approach to investing in the asset class and what makes your approach unique or more effective? How has the current economic environment been challenging or fortuitous for your approach?
We follow a fundamental, research-driven approach to investing in EM, with some key characteristics that we think give us an edge. We supplement our country calls and our top-down macro strategy with security selection and relative value strategies. Security selection has been a key driver of our funds’ alpha since inception. We have a history of strong outright and risk-adjusted returns, which we attribute to our focus on portfolio construction and integrated risk management. Of course, none of this would be possible without a technically strong team that works together to manage a single risk budget.
Still, our approach does not depend on market direction. Some of our best performance has been achieved during periods of higher volatility, when we were able to identify a greater number of market mispricings. When markets are fully valued, we’re willing to leave a few chips on the table so that we can be in a better position to trade on the next big opportunity. We don’t strive to be the best-performing fund in any one period, but instead aim to generate steady performance across market cycles that, over time, adds up to a leading position.
You manage a dedicated emerging markets fund in the U.S. and a UCITS fund offered in Europe, but you also invest in emerging markets across Vanguard’s other credit and multisector funds. How does your approach differ in a dedicated versus crossover strategy?
We believe that every investor in our active bond fund lineup should benefit from our best thinking in any of our sectors. That’s why we have the same team managing EM in both dedicated and crossover portfolios. When investing outside of dedicated EM funds, we follow the same process. The differences come from ensuring that the investments we choose are appropriate for any given fund. For example, a more conservative fund may choose from more defensive, shorter-term, or higher-rated EM bonds. Naturally, we consider the funds’ other investment opportunities when deciding on the size of the EM allocation. We’re not afraid to have concentrated exposure to our best trades, as long as the single-name risk introduced is appropriate for the funds’ overall risk budget.
What has surprised you about emerging markets over the last year?
The biggest surprise of 2024, so far, was the very strong performance of some of the riskiest parts of the market. Some of these positive stories have been driven by fundamental improvements, including reforms in Argentina and the infusion of Middle East dollars into Egypt’s economy.
However, at this point, a lot of positive momentum is already priced into these and other names and, going forward, investors should be careful. Emerging-market investing comes with plenty of risks and opportunities. Partnering with a skilled active manager in a dedicated EM strategy is an effective way to manage risk while positioning for alpha.
Related links:
· Our active fixed income approach (video, issued April 2024)
*As of May 31, 2024.
1 Admiral Shares in Vanguard Emerging Markets Bond Fund outperformed 83% of emerging markets hard currency debt funds during the past year, 96% during the past three years, and 98% during the past five years. Source: Lipper, a Thomson Reuters Company. Based on total returns as of March 31, 2024. Number of funds in category: 1-year, 208; 3-year, 201; 5-year, 188. Only funds with a minimum one-, three-, or five-year history, respectively, were included in the comparison. Results will vary for other time periods. The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit vanguard.com/performance.
Notes:
Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
Bonds of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
This document is not intended to provide tax advice or make and exhaustive analysis of the tax regime of the securities described herein. We strongly recommend seeking professional tax advice from a tax specialist.
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The sale of the Vanguard Emerging Markets Bond Fund qualifies as a private placement pursuant to section 2 of Uruguayan law 18.627. Vanguard represents and agrees that it has not offered or sold, and will not offer or sell, any Vanguard Emerging Markets Bond Fund to the public in Uruguay , except in circumstances which do not constitute a public offering or distribution under Uruguayan laws and regulations. Neither the Vanguard Emerging Markets Bond Fund nor issuer are or will be registered with the Superintendency of Financial Services of the Central Bank of Uruguay to be publicly offered in Uruguay.
The Vanguard Emerging Markets Bond Fund correspond to investment funds that are not investment funds regulated by Uruguayan law 16,774 dated 27 September 1996, as amended.