Global emerging markets: a rich canvas for alpha generation

How invests in emerging markets credit globally, using fundamental credit analysis to exploit inefficiency in a broad, deep and recognized asset class that attracts Asian commercial banks, global pension funds, international insurance companies, and local private banks and wealth managers. “The market has widened out over my career. In rough terms, the US dollar emerging market bond universe contains $1 trillion of sovereign, $1 trillion of quasi-sovereign and $1 trillion of corporate debt,” says How. With more than 80 countries and thousands of companies, there are myriad unique events and esoteric investment thesis to express views on.

Capital gains, not carry

Although some credit hedge funds use a levered income approach to magnify portfolio yield, How is a fundamental investor focusing on generating capital gains from accurately anticipating credit spread tightening and widening. He also hedges currency risks, and substantially hedges interest rate risk to isolate the credit risk component. “Fundamental investing is the bedrock of our approach. We invest in the future trajectory of a credit, not the present,” says How. 

His trading mentality focuses on spread changes rather than carry because this is a larger return driver over typically multi-week or month holding periods. “We are long into a 12% bond not because we want to sit on it for a year to clip the coupon, but rather we aim to get similar return from spread compression within weeks or months, upon the fruition of an investment theme. Sometimes we were even net payers in terms of yield. Conversely, we have no qualms in shorting a 12% bond if we think the credit is a potential downgrade or default candidate,” says How.

Dynamic risk budgeting and dry powder

“Though the strategy relies on participating in directional moves, it also maintains tightly constrained losses. The principle of minimizing losses permeates my trading habits, where my investment process starts with risk budgeting and ends with risk alignment. This gives investors plenty of comfort as we set the perimeter and telegraph risk-taking ahead,” says How.

Just as market cycles vary greatly, so too does the risk budget for an active and dynamic manager like How. In more specific terms, he uses a distinctive metric for ex-ante risk management, dubbed PV 10%: “We dynamically allocate our ex-ante risk using PV 10% as the key measurement, which is based on 10% movement on the credit spread of underlying positions considering credit spread is our main source of return as well as main source of risk. It is calculated as the value at risk divided by market value”.

He traded a similar strategy for nearly a decade at Nomura, whereas the current strategy has been tailored and optimized. “Strategy at GaoTeng was recalibrated to fit inside more rigorous risk parameters. We set a strategic 4% ex-ante risk budget over a typical 10-year credit cycle,” says How.

He very seldom uses up the strategy’s risk limits and keeps some dry powder to opportunistically deploy. “That was deliberately conservative partly because forecast risk can understate likely realized risk at the nascent and final stages of a cycle. In the belly of the cycle where there is higher degree of market certainty, we would be more comfortable using more risk,” explains How.

Relationships locate liquidity  

Whether tactical positions are held for typically less than a month or strategic ones for more than a month, liquidity is essential, and this has changed over the years: “Liquidity was good until the GFC in 2008, whereas the sell-side today is doing less intermediation and holding less inventory. Electronic trading based on RFQs (request for quotations) can be useful for smaller tickets but for larger trades of 10-20 million we still benefit from relationships”. How expects to be able to liquidate the book in five business days with minimal frictional cost: “Most importantly, liquidity is only afforded to the best counterparties. Indeed, our public hard-currency bond tilt and high-churn strategy have put us in good stead when dealing with brokers during such periods”.

Thematic alpha seeker

Notwithstanding a vast and deep global emerging markets asset class, How’s strategy expresses an eclectic suite of themes to identify the best “ahead-of-the-crowd” opportunities, where he utilizes a thematic filter to narrow down the investible universe. “We don’t profess to cover each issuer within the universe but focus on those with high-quality alpha potential.” Typically, one common theme is to spot the right rating bucket. Over his career, How has often seen a credit cycle of seven-year bull and three-year bear markets: “In a credit bull market, we look to identify rising stars candidates which will be upgraded from high yield to investment grade, and might see their spreads compress by 150 basis points generating capital gains of perhaps 8-10 points on a five- or six-year bond. In a credit bear market, we focus on ‘fallen angels’ that will be downgraded from investment grade to high yield with spreads widening significantly”.

Capitalising on Covid volatility

Back in 2019, How believed that global credit markets had already entered into a bear cycle, as the 4Q 2017 default rate was at record lows and spreads were very tight. “Default rate and credit spread are two crucial barometers to gauge the credit market,” How explains.

Although he was briefly tactically long in January 2020 to exploit seasonality effects, he aptly switched back to a bearish bias and rebalanced the risk budget, as he saw markets were too complacent towards the virus. “There was not even a window for investors to capitulate into during the first week of March 2020. Valuations were thrown out of the window as investors ruthlessly hit bids to raise cash to meet margin calls or fund redemptions,” How recalls.

While the extent of the global liquidity crunch was not expected, How’s theme identification was still highly successful, attested by the significant alpha generation even while utilising a very small risk budget. “Thematically, we looked for sectors that were vulnerable to a supply chain disruption. Aviation, autos, commodities were identified, based on extensive comparative research of crises including 9/11 in 2001, SARS in 2003 and the Japan nuclear disaster in 2011.”

China property: recognising the writing on the wall

Despite China’s economic resilience, its credit market marches on a different drumbeat that closely follows regulatory policies that create boom-to-bust cycles. The most recent crackdown resulted in a distressed property sector. “Chinese property high yield is expected to have two consecutive years of default rates around 30%. The headline yields on high yield indices are probably much too high since they annualize returns on short-dated bonds that are likely to default rather than repay par,” says How.

This could be a value trap. “Recovery rates could be as low as 25 cents on the dollar and maybe even lower for offshore USD bonds, which are effectively subordinated because they are issued using an SPV (special-purpose vehicle) that has no claim on onshore assets. Previous Chinese defaults cycle after the GFC was the university bonds – all deemed as SOEs (state-owned enterprises) – and onshore creditors got the first claims while offshore investors recovered cents on the dollar,” recalls How.

How has been spot on with his calls on China property and his nimble approach and tactical risk budgeting on the sector have been successful, whereas now he reconfigures the portfolio towards quality names and is also cautiously invested within trading ranges. “At this stage with average bonds trading around 30-40 cents on the dollar we would not flog a dead horse as there is some convexity in the potential payoffs.”

The resolution of the real estate situation will involve a delicate interplay of policy factors that needs sensitive and localized bottom-up analysis. “POE (privately-owned enterprise) developers are living on borrowed times, as contracted sales plunge, depriving them of the main source of cashflow for debt repayment. Additionally, we have serious doubts on them continuing as going concerns, with land bank life of less than two year’s industry average and their replenishment capability crippled. It was also suggested that the SOE acquire projects from distressed developers to help alleviate their liquidity situation, but the main question is whether all the rhetoric will translate into concrete policies and forceful actions that can be a game changer,” explains How.

Commodity super cycle

Commodities are another huge alpha-hunting ground within global emerging markets, as How believes that the post-pandemic shortage has kickstarted the next super cycle. “The previous super cycle was the result of China expanding at 10% GDP and becoming the biggest global consumer of coal and metals. Nonetheless the 6% GDP trend growth still represents 40% of marginal global GDP contribution,” says How. He expects China’s ‘Belt Road Initiatives’ and the US once-in-a-generation Infrastructure Bill will continue to drive a global commodity boom.

Politics and geo-politics

In late 2021, How was concerned that, “The rise of geopolitical competition for local and regional influence in Europe would escalate and become persistent, considering Russia had repeatedly warned of retaliation on NATO flirting with Ukraine’s inclusion, further deploying weapons or soldiers on the border”. He formulated geo-political risk as one of his key investment themes into 2022, which played out in February, when Emerging Europe sovereigns lost a whopping 23.4% on the month according to Bloomberg*. “Everyone must be surprised by how fast the geo-politics in Eastern Europe have unraveled. Russian stocks and bonds became almost worthless on paper overnight when the US slapped sanctions on the country and her strategic state-owned corporates,” says How. 

Emerging markets moral hazard 

Restructuring of sovereign emerging markets debt is another theme that GaoTeng are examining. The pandemic has galvanized the IMF (International Monetary Fund) into stronger action to help the weakest nations, which may have budget deficits of 10% or more, and debt-to-GDP ratios between 80% and 160%. “Relief packages can delay solvency problems and kick the can down the road on defaults for another three to five years, which provides an investible window of opportunity to buy into some IMF sponsored papers. Certain African countries, for example, may be mispriced if the debt is trading below the expected haircut upon restructuring,” says How.

Nascent ESG in Asia

How’s aspiration to foster good market practices in the emerging markets is one example of ‘impact investing’ which he hopes will lead to spread compression on ‘green’, ‘social’ and ‘sustainability-linked’ bonds, as well as on issuers of vanilla paper with high ESG scores. 

However, GaoTeng is very practical and selective in this space: “We are wary of greenwashing risks and find ESG commitments in bonds are not always binding or subject to legal recourse. It is still a very nascent market in emerging markets and particularly in Asia, whereas Europe is at the forefront. We are increasing due diligence, and asking tough questions during investor roadshows on environmental, social and governance topics rather than simply ticking boxes,” says How. 

Given that How plays a credit divergence theme where he also shorts ESG-defiant issuers that could raise their cost of financing, he reckons his investment style is even more impactful than most buy-side managers.

*Source: Bloomberg, as of 28 February 2022.

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