Emerging Market Debt: Blurring the lines
Many emerging market credits look better than most in the developed world. But Joseph Mariathasan finds that progress towards approaching global sovereign debt as a single asset class has been slow
The euro-zone crisis has brought into the open what many have argued for years - characterisations of the relative strengths of emerging market and developed market credits had become so wide of the mark as to be ridiculous. Just a few years ago, euro-zone pension funds would probably have had greater exposure to Greek bonds than the whole of the emerging debt universe. Today, it is obvious that what Jerome Booth of Ashmore Investment Management refers to as the heavily indebted developed countries (HIDCs) - all the obvious names in Europe as well as the US - compare badly with emerging markets. But domestic investors in HIDCs have yet to grapple with the implications.
What happens when you look at the debt of both developed and emerging countries across the globe from a purely fundamental viewpoint? Stéphane Monier of Lombard Odier Investment Managers did just that - scoring each country based on GDP and GDP growth, macroeconomics, indebtedness, both public and private, and measures of political stability and the rule of law - and the results are revealing. Of the 10 strongest credits, six are in emerging markets. The sovereign bonds of Russia, China, Hong Kong, Korea, Singapore, Philippines, Malaysia and Indonesia are seen as some of the strongest credits on the globe on this basis, ranking above the US and UK, as do Thailand and India.
As Ashmore Investment Management's Jerome Booth points out, in the past 15 years there has been a fundamental structural change in emerging markets with the growth of domestic institutional investors combined with the creation of massive foreign exchange reserves. "Even Angola has tons of reserves, so emerging markets can often change their exchange rates anytime they want to," he says. "Brazil, China, and so on, have been good neighbours and not allowed their currencies to change."
It is also clear that HIDCs are now characterised by ‘financial repression', with bond yields heavily influenced by central bank intervention, governments with large stakes in the banking sector imposing regulations that force those banks into purchases of large amounts of government debt, and institutional investors such as pension funds driven towards purchases of government debt by accounting standards and solvency regulations.
While moving completely to a GDP-weighted benchmark for sovereign bonds presents the danger of domination by large countries with a small amount of debt and tight liquidity in their bond markets, the thrust of the argument is clear.
"We are coming to a tipping point when global investors realise they have very lopsided portfolios dominated by developed industrialised countries, in both equities and bonds, and that their portfolios do not adequately represent the changing dynamics of the global economy," says Ramin Toloui, co-head of emerging markets portfolio management at PIMCO.
Toloui believes that there will be asset migration as more investors seek balanced portfolios by moving into emerging markets. Asian markets will be key beneficiaries, with low levels of debt and high levels of reserves giving protection against currency volatility. There are already signs of such a development: "After the downgrade of the US debt, Singapore and Australia experienced inflows as some investors moved to create more balanced portfolios," he says. "In April this year, Norway's sovereign wealth fund decided to allocate investment on a GDP basis, resulting in reducing European exposures and increasing emerging markets."
That is not surprising. Monier gives the example of a Dutch pension fund that at the end of 2009 had predominantly euro-zone exposure which meant it had a 5% weighting to Greece and 3-5% in emerging debt as a whole. "They need to move from 3-5% of their portfolio to 50% in emerging debt," he suggests.
Some would argue that the notion of emerging-market debt as a separate asset class, characterised essentially by per-capita GDP rather than by any credit criteria, has lost its validity. Michael Gomez, Toloui's co-head at PIMCO, notes one distinction that is changing. In developed countries, the authorities have traditionally used counter-cyclical policy tools to attempt to achieve their objectives, whereas, in the past, emerging markets had to use pro-cyclical policies. Now he sees a reversal of those tendencies.
"Across much of Europe we are seeing rates rise dramatically amid a growth slowdown, whereas EM local rates have generally been able to move lower," says Gomez. "Some traditional measures would suggest today that emerging markets are more advanced than the developed markets in the efficacy of their policies. This is further blurring long-standing lines between markets traditionally segmented into ‘Emerging' and ‘Developed'. For example, there was talk of moving Greece to the EMD indices. We fought strongly against that. The definition of EMD is not a country in financial chaos"
Investors should perhaps ignore the distinction and make investment decisions based on objective assessments of individual countries, producing analyses comparable to Lombard Odier's scoring system. On this basis, European pension funds and insurance companies should be careful about exposure to peripheral Europe. This can sometimes be difficult to define. "For a Dutch pension fund, France is on the periphery," explains Monier, "and they are better off having Chilean debt than French, and Malaysian rather than Italian." And, perhaps more importantly, getting away from existing prejudices is difficult.
Over the next five years at least, the historical constraints will remain and large pension funds will allocate to emerging market debt as a separate asset class. But at least as a proportion of portfolios it is increasing. It accounted for 1-3% 10 years ago and was generally seen as an alternative asset; five years ago it rose to 3-5% and was considered part of the credit allocation. Today allocations are well north of that level and are being used widely to help managers achieve a broad range of portfolio objectives.