Emerging-market debt

Outlook

Emerging-market debt (EMD) prices have held up relatively well since the UK voted to leave the European Union (EU) on 23 June 2016. As we enter a period of heightened uncertainty, we do not believe ‘Brexit’ is a systemic event that will have a lasting effect for much of the EMD universe.

Over the medium term, we are optimistic on the prospects for hard-currency EMD. The macroeconomic environment remains supportive for credit. Monetary policy action creates a ceiling for spread levels below that reached in February 2016 and the more dovish US Federal Reserve provides a catalyst to push spreads tighter.

We recognise that volatility will remain elevated and there is a continued need to be both tactical in positioning as well as selective in exposure as the credit differentiation theme remains very relevant.

The same supportive factors apply to local-currency EMD markets, which coupled with attractive long-term valuations and signs of improving fundamentals lead us to have a positive outlook for emerging-market local-currency debt. Again, caution must be taken in the near term as markets digest the implications of Brexit.

Positioning

Hard currency

We were neutral in both the sovereign and corporate bond portfolios leading into the June referendum. Portfolios have cash allocations of around five per cent of assets under management, a small US Treasuries position and a defensive stance on most curves. Overweight positions are generally held in mid to higher-beta credit but are well diversified with no dominant exposures. We are underweight lower beta and more US Treasury-correlated assets which may harm performance in a sell-off though seem to offer value over the medium term. Our focus remains on buying names selectively as conditions allow due to the supportive macroeconomic environment.

At a geographical level, we favour reducing exposure to central and eastern Europe (CEE) in preference to Asia and Latin America, which are further removed from the epicentre of Brexit risk.

Local currency

We have a small overweight to emerging-market currencies. We retain our positive long-term view on the asset  class despite the recent EU vote and look to maintain our positioning. We will be monitoring risk sentiment for signs of a more sustained correction in which case we will reduce portfolio risk.

Within CEE, we are reviewing our Polish zloty versus euro position given recent underperformance. Apart from that we are not planning to change other regional allocations in light of the vote.

Portfolio duration, at 0.5 years, has not affected performance despite significant regional variations. As with our currency positioning, we look to maintain positioning subject to developments in risk sentiment.

Global high yield

Outlook

We remain cautious in the short term on the outlook for high-yield debt. Brexit will particularly affect UK and continental European high-yield bonds in the short term. The US presidential and congressional elections in November 2016 are likely to impact the US economy and market stability. Furthermore, volatility is likely to persist in the energy and metals & mining sectors and we expect the overall default rate to rise as a result.

The global default rate was above its historical average in May and may climb higher yet. However, the majority of default activity in the US looks set to be confined to commodity sectors. Additionally, we are wary of an appreciating dollar and associated oil price reversal weighing on US high yield and further growth surprises in China.

Low-risk assets are likely to be in demand in the short term during this period of heightened volatility. There has already been a significant flight to security in recent days. The high-yield market has generated strong total returns in 2016 ahead of the Brexit vote, which could lead to profit taking and outflows from high-yield retail mutual funds.

Positioning

We had been decreasing an overweight to sterling-denominated bonds through 2016 in the run up to the referendum vote as polls consistently failed to show a decisive remain decision. Exposure to sterling-denominated bonds is largely in credits expected to be less sensitive to Brexit. While the portfolio remains overweight sterling-denominated debt, this exposure helps diversify the fund from the immediate macroeconomic risk in Europe. In addition, we will look to further diversify by opportunistically increasing exposure to US dollar-denominated bonds.

We expect lower-quality high-yield to be particularly affected by Brexit risk. We have adopted a more conservative approach to the quality of bonds held in portfolios. With the likelihood of another US interest rate hike receding, we believe BB-rated debt is best placed to outperform and that CCC-rated debt will underperform. So we have increased the allocation to BB-rated debt and reduced allocations to bonds rated B and CCC.