The emerging market debt universe has expanded fast as these countries’ economies mature and their fiscal policies strengthen them further. Will Jackson examines the implications of the dramatic growth in this asset class.
The emerging market debt universe has grown from $1 trillion (£500 billion) over the past 13 years to more than $7 trillion. But despite an impressive long-term performance record the asset class has not featured at the top of many retail investors’ shopping lists in recent years.
Those seeking exposure to the rising growth, domestic consumption and economic stability of the emerging markets have been rewarded for holding equities, rather than bonds. According to Merrill Lynch, the firm’s Emerging Equity index returned more than 30% a year, for the one, two, three and five-year periods ending December 31, 2007.
Merrill Lynch’s Emerging Market Debt index, meanwhile, produced a yearly return of 13% over five years, and just single-digit performance over the shorter timeframes. However, when measured over 15 years, emerging market debt has not only beaten the equity index on an annual basis, but also all of the major American fixed income sectors, including treasuries, corporate bonds and high yield. With this and the continued volatility in equity markets in mind, will investors pay the asset class greater attention this year?
Several fund management firms certainly say so. Over the past 12 months, HSBC Investments, Investec and Threadneedle have all unveiled emerging market debt funds targeting British retail investors. Investec was the first to launch, in May 2007, when it added a retail sterling share class to its existing institutional Emerging Markets Debt portfolio. As reported in Fund Strategy on June 25, 2007, HSBC responded by unveiling the New World Income and Global Emerging Markets Local Debt funds, as part of its Luxembourg-domiciled Global Investment Funds (GIF) Sicav.
Threadneedle further widened the choice for British investors last month by launching its onshore Emerging Market Local Oeic. The launch followed a significant expansion of the firm’s emerging market debt capabilities in 2007, with the purchase of Convivo Capital Management – a specialist hedge fund business – and the appointment of Richard House from Wadhwani Asset Management. House has taken the role of lead manager on the new portfolio.
The arguments for investing in emerging market debt are broadly the same as those for investing in equities in the region. Emerging economies have thrived in recent years and many governments now have lower budget deficits and debt-to-GDP levels than those in the developed world. Some have even accumulated large account surpluses and are now net creditors. The growth of currency reserves, in conjunction with fewer liabilities, has allowed more than half of the emerging market countries to achieve investment grade status.
While some commentators, including Lombard Street Research, an economic consultancy, have questioned the strength of the emerging market decoupling story in recent weeks, emerging market debt displayed a degree of resilience during the volatility last year. The spread on JP Morgan’s Government Bond Index Emerging Markets Global Diversified (GBI-EMGD) benchmark widened by 0.82% during 2007, as investors rushed towards the security of American treasuries in the second half of the year. But the index showed signs of a recovery in December and the spread narrowed by seven basis points, with an absolute gain of 0.61% over the month.
The new wave of retail bond funds is aiming to benefit from this new-found toughness. But such funds are also seeking to tap into a specific and relatively new segment of the emerging debt market – local currency bonds. Emerging economies have traditionally raised money through dollar-denominated securities, but are increasingly seeking to reduce their exposure to foreign exchange risk by matching revenues and obligations in the same currency. As they pay down their dollar debt, governments are issuing new bonds in local currencies. Some countries, including Mexico – which learned about the pitfalls of excessive dollar borrowing during the Tequila crisis of the mid-1990s – have also offered investors the chance to switch into local currency-denominated bonds.
Peter Eerdmans, the South Africa-based manager of Investec’s Emerging Markets Debt fund, says the issuance of local currency bonds outstripped dollar debt in the “higher-grade” markets last year. But, he adds, the trend is also set to continue into the less mainstream emerging economies over time, including such markets as Chile, Colombia and Egypt. “The smaller emerging market countries are still borrowing in dollars, but that is changing as they engage with banks to issue local debt,” says Eerdmans. “The shift is a recognition from the authorities that a well developed bond market improves the economy. It allows pensioners to save money and the creation of mortgages and bank loans.”
According to ABN Amro, the increased issuance of long-dated local currency bonds is mainly being met by demand from the growing number of local pension and mutual funds, particularly in Latin America and Asia. The firm points to data from the Bank for International Settlements (BIS), the central bankers’ central bank, which shows that domestic sovereign bonds accounted for 56% of total emerging market debt in June 2007, up from 46% in 2000. The proportion of external sovereign bonds fell from 14% to 7% during the same period. Including corporate bonds, BIS estimates that local markets now account for 81% of total outstanding emerging market debt. “Pension reforms have caused the pools of domestic assets to grow exponentially,” says Threadneedle’s House.
However, external investment in local currency bonds will become more important this year, as increasing numbers of foreign mutual funds seek exposure to the asset class. Sovereign wealth funds (SWFs) are also reportedly building their local currency allocations in an effort to diversify their holdings in American treasuries. This tallies with data from Merrill Lynch, which indicates that emerging market debt has shown a correlation of just 0.16 with American government bonds over the past 15 years. Its highest correlation, within fixed income, was with the American high yield corporate bond market, where the figure rises to 0.47. Research by ABN Amro suggests that investors can maximise a portfolio’s Sharpe ratio with a 61% allocation to local currency bonds.
In addition to increased investment from external mutual funds and SWFs, Eerdmans says the World Bank’s planned launch of a $5 billion Global Emerging Markets Local Currency Bond fund (Gemloc) will be a “big underpinning” for the asset class. The fund, which will start channelling investment towards 15-20 low income countries this year, aims to help emerging market economies develop their bond markets. A manager for the fund will be appointed in the next few weeks. “The World Bank stamp of approval will open the eyes of more pension funds and investors to the asset class,” adds Eerdmans.
Local currency emerging market bonds performed well against the broader asset class last year. While the GBI-EMGD index gained 6.16% over 2007, the JP Morgan Government Bond Index Emerging Markets (GBI-EM) benchmark – which tracks the performance of local currency debt from 13 countries – returned 16.08%. The index was boosted by strong performance from Brazil, India and Turkey. This was reflected in the performance of the Investec fund, which returned 18.11% in 2007, according to Financial Express. The portfolio beat its nearest rival in the Investment Management Association’s Global Bonds sector by almost five percentage points.
Alongside the strong performance of certain individual markets, both the index and the fund were able to benefit from the continued appreciation of emerging markets currencies against the dollar – another factor likely to drive external appetite for local currency bonds. While Western investors have not always considered exposure to emerging market currencies desirable in the past – with some countries prone to bouts of hyperinflation – many have been encouraged by the adoption of disciplined inflation targeting policies.
The trend can be seen in data from the International Monetary Fund (IMF), which shows that the annual percentage changes in inflation for Colombia, Ecuador, Indonesia and Zambia all fell significantly between 1998 and 2003. Indonesia displayed the most dramatic turnaround, with its rate dropping from 58% to just 6.8% over the period. The IMF expects further improvements in 2008, and forecasts single-digit rates for all of the countries, with a figure of just 3% for Ecuador.
As a result, interest rates among the emerging economies have also fallen. While Brazil’s real interest rate of 6.5% may seem high by western standards, it is about half the level it was four years ago. Peter Marber, manager of HSBC’s GIF Global Emerging Markets Local Debt and GIF New World Income funds, is confident that better fiscal policy from emerging market governments will continue to produce lower inflation and interest rates, with further currency appreciation.
“Most emerging market currencies are undervalued in terms of purchasing power parity,” says Marber. “A historic example is the Japanese yen which has appreciated three-fold since the 1950s. Not all currencies will appreciate to the same extent, but some will.”
House, meanwhile, is also positive on currency and has positioned his $175m portfolio accordingly, with a 50% allocation to foreign exchange. Among his currency plays are overweight positions in Egypt and Slovakia. Indeed, HSBC expects opportunities in currency to drive the asset class this year.
In addition to the benefits of long-term currency appreciation, many local bonds are also offering better value, in terms of yield, than external bonds. According to ABN Amro, the average spread between local and external yields in Mexico is 3%. This is despite the fact that Mexico’s local debt is rated A+, compared with a rating of just BBB+ for its external obligations. ABN Amro says it expects the spread to contract as investors continue to focus on local debt and liquidity in the market improves further.
But despite the undoubted opportunities within the emerging markets, political risk remains a major consideration for some bond investors. Nowhere has this been better illustrated in recent months than in Kenya, which beforeDecember was widely regarded as an African success story, with strong GDP growth and a stable economy. However, the disputed election at the end of last year led to a series of bloody protests and recent reports estimate that more than 1,000 people have been killed in the violence, with a further 300,000 displaced. As well as being a humanitarian disaster, the chaos has also had a direct impact on Kenya’s bond market. According to Fitch, which downgraded the country’s long-term foreign and local currency issuer default ratings from stable to negative last month, the violence caused the postponement of a eurobond sale.
David Buckle, European head of fixed income at Principal Global Investors and a former member of a global macro bond team at Merrill Lynch, is “very constructive” on the development of emerging market debt and local currency securities in particular. However, he adds that diversification within the region remains important. “Investors should look at risk on a country-by-country basis,” says Buckle. “We focus heavily on Eastern Europe and the political situations vary significantly. We use a combination of country visits and subscriptions to information services, but investors who do not have the skill-sets should rely on diversification.”
Marber, meanwhile, is also using a combination of external information – including data from the World Bank – and HSBC’s “global intranet of opinion”, to assess political risk. As a result, he is avoiding exposure to Argentina and Venezuela. Tensions between America and Hugo Chavez, Venezuela’s radical president, remain high, and recent reports of calls by Chavez for a South American military alliance are unlikely to bring about a thawing of relations. Political risk rose significantly towards the end of last year as Chavez sought the right to stand for re-election indefinitely.
Despite the rejection of his proposed reforms on December 2, and a consequent rally in the Venezuelan bond market, Marber says the country remains uninvestable. He points to its failure to make the most of rising oil prices in particular. “Venezuela has been making bad choices and is not on our improving countries list,” adds Marber. “It is the only really volatile big country left.” Other firms, including Threadneedle, are minimising their exposure to South African bonds, following the election of Jacob Zuma as leader of the African National Congress (ANC), which has raised the prospect of infighting within the party.
However, not all is political gloom within the emerging markets and Investec highlights Brazil and Turkey as examples of markets that have provided positive surprises in recent years. In its latest “Emerging market debt roadmap” report, published in December, the firm points to the Brazilian election in 2002. Fears over the election of Luiz Inacio Lula da Silva – or “Lula” – caused a 24% fall in the Brazilian real in the two months before polling. Spreads on dollar bonds also widened significantly, but the concerns proved unfounded. Despite his left-wing past, Lula has proved to be a relatively market-friendly leader and installed a strong economic team.
A similar situation arose last year in Turkey, with concerns surrounding the election of Abdullah Gul, the country’s former foreign minister. Over the course of 2007, Turkey also made military incursions into northern Iraq and temporarily suspended several European Union accession negotiations. However, as highlighted earlier, the Turkish local currency bond market was one of the best performers last year, with a return of about 50% in dollar terms. The performance also benefitted the Investec fund, which had equal allocations of 12.9% to Turkey and Brazil at the end of December.
Africa also offered several positive fixed income stories in 2007, despite the crisis in Kenya. As discussed in Fund Strategy on January 8, 2008, Nigeria completed a government debt issue in October, and this was followed by Gabon’s $1 billion bond issue in December. In the same month, Ghana became the first African country outside South Africa and Nigeria to issue dollar-denominated corporate bonds. Ghana Telecommunications issued $200m of debt carrying an 8.5% coupon and maturing in 2012. According to Iroko Securities, which arranged the issue, the firm expects to bring other sub-Saharan corporates to the market in future.
Eerdmans says he did not participate in the Ghana issue, because the bonds were dollar-denominated, but he expects to see some expansion of local currency corporate debt issuance in the larger markets of South Africa, Russia and Brazil. However, according to BIS, local demand for emerging market corporate bonds appears to be moving in the opposite direction to government debt. The percentage of corporate debt held domestically fell from 32% in 1995 to 25% in 2007. External investment rose, meanwhile, from 9% to 12%. “We will see continued corporate issuance in hard currency [dollars], although that will change further down the track” adds Buckle.
A more immediate development within emerging market debt is likely to be the continued growth of derivatives. According to BIS, the growth of foreign exchange and interest rate derivatives – including interest rate swaps and floating rate notes – has outpaced that of outstanding emerging market bonds.
Marber says the trend is an important one. “Derivatives have mushroomed. It is a useful way to tailor your exposure and, in some markets, credit default swaps trade more frequently than the underlying bonds.”
However, some commentators say the challenge for emerging market debt in the short term is simply to maintain its performance. A Merrill Lynch report – titled ‘The growing global credit pandemic’ – urged investors to “stick with higher-quality assets globally and to begin to rotate towards developed markets”. The firm pointed to indications of increased default risk in Asia, and a fall in the Baltic Dry index, which measures shipping rates. According to Merrill Lynch, the index has fallen about 40% since last November, signalling a slowdown in Asian economic growth.
In its latest quarterly review, BIS also casts doubt on the decoupling of emerging market debt from other classes of fixed income. The apparently strong performance of the emerging market bonds index towards the end of last year merely served to mask the effect of worsening sentiment in the broader credit markets, it says. The bank highlights the widening of emerging market spreads in November as evidence, following an initial period of tightening after the onset of the credit crunch.
How emerging market debt reacts to continued uncertainty in the markets, or even an American recession, over the coming months will give an indication of just how self-sufficient countries in the region have become. Many emerging economies are undoubtedly in a better position than they were 10 years ago, with lower budget deficits and better credit ratings. Inflation in the region has fallen dramatically and currencies appear to be on a long-term course of appreciation against the dollar.
Governments, meanwhile, have reduced their exposure to foreign currency risk by raising money with local currency bonds. While these securities are primarily being bought by local pension and mutual funds, they are also attracting interest from SWFs seeking diversification from dollar-denominated securities. The new generation of British mutual funds are also buying, offering retail investors a diversified route into the asset class, thereby mitigating the threat of political risk. The fundamental long-term arguments for investing are compelling, but much depends on how the funds fare if the market turbulence continues.