EM debt comes of age through crisis
No one would envy the job that developed market pension fund managers face over the next few years. After the huge destruction in wealth brought about by last year's credit crisis, they have a lot of catching up to do. Compounding the problem are historically low interest rates and a highly uncertain inflationary outlook. It is becoming increasingly important for pension managers to branch out into new asset classes to seek high risk-adjusted returns with low correlations to existing portfolios. Emerging market debt denominated in local currencies provides just such an opportunity and is worth serious consideration as a core component of diversified pension portfolios.
Emerging market sovereign issuers have had a long history of involvement in international capital markets through the issuance of hard currency denominated bonds. However, over the past decade, improvements in macroeconomic fundamentals, institutional structures and governance has enabled central banks to drastically increase the issuance of local currency bonds. Growth of the asset class since 2002 has been rapid, rising from less than 40% of the total market value of bonds outstanding to more than 75% by June 2009, using JP Morgan indices as proxies for total emerging market debt asset class.
In addition to increased local issuance, this change was enabled by countries actively pursuing a policy of lowering their external debt burden through buybacks and reduced hard currency refinancing resulting in several countries becoming net external creditors. Consequently, issuers have become less dependent on foreign capital flows, improving both creditworthiness and policy flexibility.
Recently, the global crisis has shown that emerging markets haven't fully shed their need to attract foreign capital to finance infrastructure development and economic growth. As risk aversion rose, capital flowed into the perceived safety of US Treasuries, and spreads widened to reflect increased refinancing risks. However, as the crisis intensified with the collapse of Lehman Brothers, the finances of these countries remained relatively robust and emerging markets did not experience the levels of default and contagion that investors expected. Consequently, investors saw value in emerging markets sovereign debt as pricing was not reflecting improved fundamentals and spreads compressed sharply. Sovereign issuers were able to take advantage of returning risk appetite early this year and refinance at reasonably low historical rates.
In analysing the more recent performance of local currency bonds it is worth keeping in mind two important factors. First, the global credit crunch provided the first real stress test for this new breed of emerging market economies. The bulk of the changes we mention have occurred over the past decade, fuelled by a commodities and exports boom. This period is remarkable for the lack of any widespread emerging markets crisis beyond localised problems such as the 2002 Argentine default.
Second, the recent global economic problems originated in the developed world, so the impact on emerging markets came from the withdrawal of risk capital and falling export demand, not from underlying problems in these countries' domestic economies. So what actually happened to the asset class over the past two years and how did bondholders react?
On a risk-adjusted basis, local currency bonds (proxied by JP Morgan's GBI EM Global Diversified index) have compared favourably to the alternatives, particularly US high-yield bonds and emerging markets equity. It also helps to break the bond returns down into currency and credit segments. By currency, we refer to both foreign exchange movements and the returns from short-term rates. Currency makes up approximately three-quarters of the risk-adjusted performance, with the remainder composed of higher yields from upward sloping yield curves and spread compression. Correlations of returns over this period were also low, yielding diversification benefits in conjunction with a portfolio of developed market assets.
However, through the worst of the crisis (the year to November 2008), correlations increased dramatically as rising risk aversion (even a little panic) led to a massive withdrawal of capital from all risk assets.
The recovery period of the past three quarters has been much more interesting. This was when regional characteristics led to wide divergence in returns that active managers could capitalise on.
Countries with lower external financing requirements and free-floating exchanges rates benefited the most for two reasons. First, the lower external refinancing requirement meant reduced imbalances and lower default risk for bondholders. As risk-seeking investors returned to the market, these countries were the first to attract capital.
Second, free floating exchange rates meant that a currency sell-off had the simultaneous effect of increasing export competitiveness, thereby cushioning economic and market contraction. An improving trade balance can also offset capital account outflows and provide support to the currency.
For investors weighing market opportunities as risk appetite picks up and confidence returns to markets, emerging market local currency debt should be given serious consideration. These countries now comprise more than 30% of the global economy and are under-represented on a GDP-weighted basis in developed market pension funds. More robust fundamentals, effective governance and a strong outlook should help these countries outpace the economic growth of the developed world and provide attractive opportunities for investors. At a time when western governments are flooding the market with new bond issuance, investors are rightly concerned about over supply and will seek alternatives to protect against rising dollar yields. The historically high risk-adjusted returns and low correlation benefits of emerging markets debt provide the answer and pension fund managers should be getting involved.
Lewis Jones is a fund manager with Rexiter Capital Management in London