Leaning into world's riskiest bonds a loser's game, warns Pimco

Pacific Investment Management Co., one of the world’s largest asset managers, says investors have misplayed emerging markets by focusing too heavily on risky bonds. 

In a white paper released Tuesday, Pramol Dhawan, the head of emerging markets, and Michael Story, executive vice president and emerging-markets fixed income strategist at the $2 trillion asset manager, said investors should avoid the “temptation” to migrate toward crowded positions in high-yielding countries. 

“That game may have worked two decades ago,” they wrote. “But it is a difficult game to win today.”

Instead, money managers should prioritize bonds from lower-risk countries with reasonable valuations, and use emerging-market debt as a way to diversify from domestic credit risks, they said. Dhawan’s $4.5 billion Emerging Markets Bond Fund has delivered 23% returns in the past year, beating more than 90% of peers, according to data compiled by Bloomberg.

“The case for EM debt should not be anchored on spreads, yields, or some other valuation metric. It should be based primarily on diversification benefits,” they wrote. “Many investors today use EM debt for the wrong reasons, manage it imprudently, or overlook the best parts.”

Debt from developing nations has seen a third year of outflows due to tight global financing conditions and geopolitical conflicts. This year, debt from high yielders has handed investors a 12.5% return — led by countries like Argentina and Bolivia — compared to returns of 3.5% for high-grade EM credits, according to a JPMorgan Chase & Co. index.

Once-booming economic growth in emerging markets has slowed, leading Dhawan and Story to focus more on global factors when evaluating the asset class.  

Some investors have already turned cautious ahead of the US vote, with JPMorgan’s global head of research Joyce Chang recommending a neutral approach to emerging markets on election risks.

On the political front, Dhawan and Story said a bottom-up strategy is needed to evaluate risks in the developing world. They’re steering clear of the type of top-down analysis that focuses on harnessing excess yield, which has predominated the approach many took starting two decades ago.

“Investors who were leaning into risk and trying to time the market around macro events started to play a loser’s game,” they wrote. “EM often rewards investors who minimize losses rather than maximize gains, and who avoid concentrated positions in high-yielding countries.”