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Avoiding "diversification decay" in emerging-markets debt

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      By Emerging Markets Debt TeamEaton Vance Management

      Boston - Since the global financial crisis, there has been a confluence of three important trends: increased emerging-markets (EM) debt holdings by mutual funds and institutions, index-based EM portfolios, and more frequent risk-off/risk-on episodes.

      Taken together, these trends are changing the nature of EM index risk - it is becoming more like systemic, developed-markets risk. For the majority of EM debt investors looking for exposure that doesn't mirror trends in developed markets, this can represent worrisome "diversification decay."

      The chart below shows how for the 19 currencies in the JPMorgan Government Bond Index - Emerging Markets (GBI-EM), correlations with global high-yield debt increased significantly during the global financial crisis, and have remained elevated since then. In contrast, correlations of off-benchmark currencies advanced only modestly and remain much lower.

      Correlations of EM benchmark currencies have grown dramatically.

      EM blog chart

      Sources: Eaton Vance, Bloomberg LLP, March 2019. Benchmark currencies are represented by the 19 currencies of countries in the JPMorgan Government Bond Index - Emerging Markets (GBI-EM), a common measure of locally denominated emerging-markets debt. Off-benchmark currencies are represented by more than 100 countries not contained in EM indexes that have tradeable currencies, as determined by Eaton Vance. Data shown represent the median values for their respective universes. Global high-yield bonds are represented by the BofA/Merrill Lynch Global High Yield Index, which measures USD and non-USD denominated, noninvestment grade corporate securities. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Data provided is for informational use only. Past performance is no guarantee of future results.

      Thus, diversification decay is a growing problem for the many EM portfolios tied to the GBI-EM However, we believe it can be largely avoided through active strategies that focus on country-level macroeconomic and political research, and standalone analysis of specific risk factors such as currency, credit spreads and interest rates.

      Bottom line: Standing apart from the indexation herd in this fashion through active strategies like those pursued by the Eaton Vance Global Income team can potentially preserve the important diversification benefit of EM debt investing.

      Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, currency exchange rates or other conditions. In emerging or frontier countries, these risks may be more significant. Diversification does not guarantee profit or eliminate the risk of loss.