Emerging Market Debt: Localising, globalising
Joseph Mariathasan finds that fast developing emerging debt markets present opportunities for risk-taking and challenges for benchmarking and performance measurement
The first thing we need to ask about emerging market debt (EMD) is whether it should be regarded as a separate asset class in its own right. What used to be a well defined, narrow investment opportunity is anything but that today.
For starters, what exactly is the difference between an ‘emerging' and an ‘emerged' market? In the bond world, the difference is certainly not about credit spreads any more: yields on Greek securities are far higher than those of most emerging countries. Neither is it really about size: EMD now makes up some 20% of the global bond market.
Emerging markets used to issue the majority of their debt in US dollars, but now the $1.4trn (€1.07trn) of outstanding hard currency issuance is dwarfed by the $6.8trn in local currencies, according to end-2009 data from HSBC/Halbis. Expect the shift to local currency EMD by institutional investors to continue because of the yields available and the size of the markets, as well as the belief that emerging market currencies are likely to appreciate long term.
What about the lack of corporate issuance? Think again: emerging market corporate debt issuance is increasing as companies in the developing world expand to the size that hard and local currency issuance becomes feasible, to the extent that hard currency corporate issuance now exceeds that of sovereign debt. The range of credit ratings perhaps speaks of differentiation - some Asian issuers enjoy AA status while Argentina and Venezuela languish at CCC - but again, developments in Europe warn against any complacency on this.
"People used to ask, ‘What is an emerging market?' and the answer would be, ‘I can't describe it but I'll know it when I see it!'," as Peter Marber, head of the HSBC/Halbis EMD team, puts it. Nowadays, the ‘walks-and-quacks-like-a-duck' methodology is somewhat less robust.
Technically, emerging markets are defined on the basis of GDP per capita and on that basis, the poorly performing economies of the PIIGS countries would be regarded still as developed. Greece will not join the major EMD indices - no matter what happens to its bonds. Despite this distinction, managers like Marber would argue that EMD today is an integral component of global debt markets. But that has not yet been reflected in the global aggregate bond indices and perhaps as a result, investors are still generally underweight. Despite this, there certainly appears to be a trend to diversify bond exposure away from the developed markets. Bluebay Asset Management, for example, saw a 60% increase in EMD assets under management between the end of Q1 2008 and the end of Q1 2010, according to head of EMD David Dowsett.
Institutional investors need to address the question put by Michael Hasenstab, co-director of Franklin Templeton's EMD group: "Are US Treasuries really the risk free asset they have been seen as in the past, given the developments in the marketplace, with the US deficits essentially being financed by printing money?" While developed markets have debt-to-GDP approaching 100%, in emerging markets, the figure falls to below 40%. Hasenstab says: "If you are concerned about fiscal indebtedness, the ability to repay your debt, it's actually the emerging markets that are in the better position."
With the EMD marketplace split between hard currency sovereign, local currency sovereign and essentially hard currency corporate debt, institutional investors also have to decide whether they should allow a manager to switch between these sub-categories or explicitly award mandates for one or more of them. The marketplace may even be evolving to the position where hard currency sovereign debt is just seen as one element of global hard currency debt markets, while local currency debt is the real opportunity for generating higher returns through both higher bond yields and currency appreciation.
Hard currency debt means essentially taking views on spreads above US Treasuries, while local currency debt means taking views on both local interest rates and currencies, both of which can be tackled independently. Fund managers need to have processes that tackle both type of debt in a systematic manner, as Peter Eerdmans, head of EMD at Investec explains: "We produce score cards for currencies, local bonds and dollar debt," he says. "Currencies are much more driven by the external situation. Bonds are driven by local inflation and monetary policy."
Currency risks can be hedged out using non-deliverable currency forwards and as these have low yields as the currencies are very popular, hedging can be cheaper than implied by onshore interest rates, adds Eerdmans.
The major local currency benchmark index has just 13 bonds in it, yet managers such as Investec may invest in as many as 40 countries across the risk spectrum. These may include what Investec see as low-risk Taiwan and the Czech Republic, to medium-risk Chile, Poland, Russia, Mexico and India, to the higher-risk Philippines, Nigeria, Indonesia, Turkey and South Africa, as well as the true frontier markets such as Ghana, Uganda and Sri Lanka.
While some managers use purely qualitative assessments of risk, others try and incorporate an element of objectivity through country risk models. Investec has a quantitative model, developed in 1998, that assesses relative currency risk based on five fundamental factors that have proven ability in forecasting currency crises. For individual local debt markets, it also uses other metrics such as relative values. They then incorporate judgemental scores based on fundamental economic factors, country risk, valuations and market behaviour. "Countries can move through our scorecard steadily over the course of a few months from, for example, top to middle," explains Eerdmans. Idea generation for actual trades is based on these bottom up scorecards alongside an assessment of the top down macro implications. The size of trades is determined by using a metric of risk units defined as deviations from the benchmark, and the relative size of risk units is based on a wide range of risk measures including historical volatility, credit worthiness and liquidity.
Defining a benchmark portfolio for this risk-taking is a fundamental issue that is not addressed adequately with the present generation of indices. Indeed, some argue that an absolute return approach is the most sensible, since any index ends up being an arbitrary collection of disparate countries. Fund managers often beat indices by increasing risk by taking overweight and underweight positions against the benchmark or off-benchmark positions - perhaps local currency bonds where a hard currency benchmark is being used, or moving outside the benchmark universe of countries.
"Ultimately managing risk comes down to researching and understanding the bets that you are making," says Hasenstab. "So to minimise risk means understanding the countries that you are investing in." On the other hand, there are firms such as Pictet that see themselves providing a defined outperformance against a stipulated benchmark.
EMD indices are not segregated by credit rating despite the fact that the rest of the bond markets are, and the corporate framework governing investment in the debt markets is focused around a credit rating demarcation.
The coming of age of EMD does require a reappraisal of the current set of indices that provide the framework for investment in the marketplace, and the creation of new self-consistent benchmarks and indices that while inevitably not perfect, at least provide a more realistic framework for investment in EMD of all credit ratings. As Bluebay's Dowsett says, EMD has moved from an opportunistic to a strategic investment and the framework for analysing it within an institutional context needs to reflect that.
EMD is an asset class in which any broad-ranging fixed income manager now has to have expertise, and the shifting of assets into the EMD markets by institutional investors from developed markets is a long-term trend that will probably not be reversed.
But the perceptions and prejudices that influence investor decision-making in the short term - as seen over the last few years - means that EMD will be subject to short-term volatility arising from contagion from the developed markets.
HSBC/Halbis is only 65-75% net invested in its absolute return EMD strategy currently, and is keeping its risks low as the markets still react to the European crisis in sovereign debt ratings. Marber warns: "With the EMD markets held hostage by outside factors, many strategies may not work as the EMD markets get jolted, even though EMD is an attractive long-term prospect."