(Bloomberg) — Hedge funds dedicated to emerging-market debt are increasingly turning to risk-mitigating strategies to ensure they lock in double digit gains as a broad rally in developing nation assets deepens.
After a banner first half of the year, hedge funds targeting EM debt have returned nearly 13% on an annual basis — more than their peers positioned in any other asset class, according to data based on Bloomberg indexes.
The latest global financial flows data shows the asset class remains thriving and the extra yield investors demand to hold the sovereign debt of developing nations over US Treasuries just hit a 15-year low. Such tight pricing, along with uncertainty over US policies and global conflicts, is pushing hedge funds to curb risks as they ride the historic rally.
The funds do this by swapping longer-maturity bonds in their portfolios for less risky shorter-dated ones. They also focus on higher-rated debt and the most-liquid securities while keeping an ample cash pile.
“Do you just want to be massively long on credit on these valuations? I’d say probably not,” said Anthony Kettle, who co-manages BlueBay Emerging Market Unconstrained Bond Fund with Polina Kurdyavko and Brent David. “Having a little bit of dry powder evidently makes sense, and also running elevated cash levels.”
To be clear, Kettle said, there’s still a “decent environment” to gain additional returns as funds become more selective and can profit from both rising and falling asset prices, unlike index-based investors. The $784-million BlueBay fund has returned 17% over the past 12 months.
Investors have taken advantage of EM inflows stoked by increased interest for alternative assets amid US policy unpredictability, which has also weakened the dollar. While many developing countries have come out of distressed debt levels as sentiment improved, further risks include another Iran-Israel flare up and potential additional increases in US tariffs, including on the buyers of Russian energy.
President Donald Trump’s administration has caused a “breakdown of the traditional safe haven correlations” by shaking up the post-Cold War world order, creating an “unusual and unpredictable” environment, said Demetris Efstathiou, the chief investment officer of Blue Diagonal EM Fixed Income Fund.
“It is very hard to predict what they will do next with tariffs, and on top of that you have ongoing wars,” Efstathiou said.
His fund is “very conservatively” positioned with shorter-maturity bonds and he avoids weak credits to protect the portfolio in the event of a global slowdown and market downturn. He has increased holdings of AAA- and AA-rated EM sovereigns along with less-indebted countries with large domestic markets like Brazil, Turkey and Mexico.
EM-dedicated bond funds have received $31 billion in inflows year-to-date, with positioning increased in each of the last 14 weeks as global markets recalibrate after an era of US dominance.
A near-record $5.7 billion piled into the asset class in the week though July 23, according to EPFR Global data provided by economists at Bank of America Corp. For some, flows of such a magnitude signal that EM debt is already predicting the best-case scenario.
“The market is now priced for a Goldilocks scenario with the risk of a severe recession receding significantly and expectations” of one or more rate cuts by the Federal Reserve, the $847 million Enko Africa Debt Fund said in a letter to clients. Managed by Alain Nkontchou, the Africa-specific hedge fund has returned 24% over the past year.
Nevertheless, the expected volatility means that traditional buy-to-hold trades may not necessarily succeed and that hedge funds will prioritize holding more liquid assets to ensure an easier exit in case sentiment turns, according to ProMeritum Investment Management LLP, a $700-million fund that invests in developing markets outside China.
“Liquidity management will be critical in the second half of the year because of an unpredictable environment and geopolitical risks,” said Evgueni Konovalenko, managing partner and head of strategy at the firm. Such a focus is needed “to take advantage of both short and long positions with sudden policy changes and a daily barrage of headlines.”
–With assistance from Jorgelina do Rosario.
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