Why traditional defensive investing has generated volatility and poor returns

Ask VanEck’s Eric Fine if investors have missed the boat on returns in developed market bonds and he scoffs.

“For developed market bonds – what returns? They’ve been a disaster for 20 years,” he says.

Fine points out that we’ve seen yield curve control in Japan and two bond crises in the Eurozone, aka “debt paying you nothing”.

“The big problem is most investors are standing on ground they don’t understand. They’ve been told treasuries, the dollar, the global AG, US investment grade bonds should be the bulk of your portfolio and you’re never supposed to worry about them. For 20 years, they’ve generated volatility and poor returns,” says Fine.

But where should investors be looking instead?

According to Fine, the answer is in emerging markets fixed income.

Emerging markets have worked hard to bring debt levels down, and have built out their trade networks beyond what we’ve seen in developed markets. They are also investing in fixed income markets.

“Other central banks are buying EM bonds as reserve assets and they’re selling treasuries which means there is secular demand for these bonds,” says Fine.

He’s seeing enormous opportunities across emerging markets, pointing to China and Brazil as areas he’s investing in. Side note to Aussies: Brazil has similar inflation levels to Australia but interest rates of 11%. It’s a heavy exporter and Fine says it has “more dollar reserves than they do dollar debt.”

In this episode of The Pitch, you’ll learn why you should be considering EM bonds over developed markets, and how to manage risk in this space. Plus, Fine also shares examples of where he is investing right now. 

Please note this interview was filmed Tuesday 7 May 2024.

Edited transcript

Have investors missed the boat on returns when it comes to developed markets?

For developed market bonds? What returns? 

They have been a disaster for 20 years. The developed market bonds are the Eurozone bonds which have had two crises. What were those crises? A lot of debt paying you nothing. Then yield curve control in Japan. That's financial suppression. You are supposed to escape financial suppression. That's why Japanese money flows out. Our money is already out. So, what returns? 

I think that's been the big problem - most investors are standing on ground they don't understand. They've been told Treasuries, the dollar, the global AG, US investment grade bonds should be the bulk of your portfolios and you're never supposed to worry about them. For 20 years, they've generated volatility and poor returns.

Why should investors be looking at emerging market bonds instead for the best opportunities?

They've been the best performers for the last 20 years and the reasons they have performed are still there. Low debt pays you more. They are winners from the new geopolitical configuration. They're trading with each other more which reduces costs, lowers the neutral real rate if you want to call it that. 

Also, when you see headlines like UAE agrees with India to accept INR for oil, not dollars for oil, or Brazil agrees with China the same or Saudi Arabia with China. Why do you think the UAE central bank does with INR and CNY? Over time, they don't want a pile of cash. They invest in those bond markets. That's exactly why Saudi Arabia is up to here in Treasuries. 

What this means is other central banks are buying EM bonds as reserve assets and they're selling Treasuries, which means there's secular demand for these bonds. Their financing is sorted. Central banks are not just buying gold and selling Treasuries, they're buying EM bonds. That's fundamental. Who are DMs borrowing from? They're borrowing from their own central bank. When I was in school, that was a major no-no. We have a financial crisis, and then all of a sudden, it's a legitimate policy tool.

How can investors balance the risks of investing in emerging markets?

Access all the opportunities.

A lot of institutional investors for decades have gotten interested in EM because it answers a basic question. We want low debt and we want to get a coupon on our bonds. What institutional investors initially did was say, "We get that, we won't load. Debt pays you more, but what's the highest beta? Local currency. Let's do it all in local". Local doesn't always work.

Others said, "It's safer. Let's do it in dollars." Dollar-denominated bonds don't always work. So we created the world's first actively managed blend fund that says local is attractive, dollar-denominated bonds are attractive, and corporate bonds are attractive. Find the best in that group so you are always finding the best in EM, and therefore you are not vulnerable to those top-down concepts like the dollar going down (it's not always clear what that means in EM).

Find blend managers that can find the best in EM and don't confine them to a small world.

Can you share some examples of how you are investing in this space?

Brazil has very high real interest rates - a very hawkish central bank. Inflation is about the same as it is in Australia. Interest rates are 11% and it is a big exporter that is up to its neck in dollars. They have more dollar reserves than they do dollar debt at the central bank level. It's very unusual to have countries like that. That's one great example of a country with an independent central bank that's focused solely on inflation and is paying you triple what the yields are in the developed market countries with similar inflation and nowhere near the strong balance sheet that Brazil has. Now Brazil has problems. It arguably does have too much debt so it isn't out of the woods, but it is an example.

Another interesting opportunity that is shorter-lived is China.

We've actually had China as one of our top five performers for the last three years in a row. The first thing is, we didn't own it when it blew up. Investment-grade Chinese corporate bonds priced at par weren't attractive in our process. We ignored it, it fell apart. The reaction was so overdone and the closure of funds was so overdone that real value was generated. We found small diversified opportunities that were little engines that could. 

Everyone is negative on China and so, by definition, if you can find cheap bonds, they have the fundamentals and everyone hates it, we know what Paul Tudor Jones says. When you have the technical and the fundamental, you size it up. We can't size it up too much in China because it is risky and we have constraints linked to our benchmark. There can be great opportunities, even though I think the China story may become uninvestible - sanctions are likely coming, tariffs are coming, but that doesn't mean you can't find opportunities. It is a more time-limited one.

Those are two examples. Brazil is a more traditionally obvious headline one, but even in China, which arguably has some bad events coming down the pipeline, you can find positive returns for your funds with small diversified positions. These are totally uncorrelated to DM. When China's going up, it has nothing to do with the Fed, nothing to do with stocks, nothing to do with oil prices. It's just whether those things are cheap and whether they are going up and it's uncorrelated, which is huge for investors.