Emerging Market Debt: What role do indices play?
The key sub-components of the emerging market debt (EMD) are the original hard currency sovereign debt, followed now by local currency sovereign debt and, increasingly, hard currency corporate debt. At some stage local currency corporate debt may also come to have significant size. There are two questions that need to be addressed when considering the role of an EMD bond index: What should its composition be? And how closely should a manager be asked to stick to it?
The international market originated in hard currency sovereign debt, and not surprisingly, the most prominent benchmark has been the JPMorgan Emerging Markets Bond Index Global (EMBI Global), which tracks total returns for US dollar-denominated debt issued by emerging market sovereign and quasi-sovereign entities, including Brady bonds, loans and Eurobonds. Yet adopting a hard currency benchmark may constrain a manager unduly when it is local currency that offers most opportunities. Then again, allowing managers wide leeway in taking off-benchmark positions has its own obvious drawbacks - it becomes difficult to control and monitor their risks and reduces the role of the index to a mere performance comparison indicator, rather than an integral component of risk management. But as Michael Hasenstab, co-director of Franklin Templeton's EMD group argues: "There is an increasing recognition that managing EMD against an index is not minimising risk at all, but just providing comparisons against an arbitrary allocation of countries."
Capitalisation-weighted bond market indices of any type suffer from a major flaw - the more debt that an entity issues, the greater the proportion in the index, although more debt issuance is usually associated with a weakening credit rating. Nowhere is this truer than in EMD: managers who stuck closely to the JP Morgan index weightings during the Argentinean crisis found themselves loading ever more investment capital onto a runaway train. JPMorgan subsequently issued indices that have 10% caps on single-issuer weightings - a pragmatic solution that suffers from a lack of any theoretical framework.
Still, indices have performed a useful role for investors in giving a presentation of the asset class that could be analysed in depth as part of a systematic approach to asset allocation. The JPMorgan EMBI Global has proved to be one of the best performing financial indices in the world, as Peter Marber, head of EMD at HSBC/Halbis, points out, and that has proven a key factor in the growth of interest from institutional investors in EMD as a whole. Yet, unlike most bond indices, it is not characterised by a credit rating: a decade ago it tended to be lumped-in with high yield debt, but that would be a nonsense now that 60% of its composition is investment grade.
More recently JPMorgan introduced local currency indices, but as Marber points out local currency indices are at an embryonic stage: "We are investing in around 30 countries rather than just the 13 in the index." At Investec, Peter Eerdmans, head of EMD, can have 30% of his strategy in off-benchmark positions using a local currency universe of 40 countries. "In the local currency universe, a big market capitalisation is not a sign of weakness as in the developed markets, but a sign of development," he observes. "If a country gets into the local market index, it is a good sign."
An index benchmark is important for Pictet, which sees itself as an active benchmark manager. However, head of EMD, Simon Lue-Fong, is open as to what the ideal index composition should be. "There is no right way or wrong way, and any index approach has both positive and negative factors," he says. Marber also takes the benchmark index seriously, although Halbis can have 25% off-benchmark positions. "Clients expect us to respect the benchmark and we try and stay within the credit ratings band, but incorporating local currency bonds and corporate can generate a lot of outperformance." The problem for investors is that this can make it difficult to compare one manager with another: managers can producing more alpha against the index just by taking more risky off-benchmark positions.
Historically, it has been cap-weighted indices that have dominated both equities and bonds. Given the limitations of capitalisation indices, a more popular trend may be to adopt alternatives. PIMCO, for example, has recently launched its Global Advantage fund based on a proprietary GDP-weighted index Global Advantage Bond Index (GLADI), with prices produced by Markit.
Lombard Odier has produced a more structured proprietary EMD index based on a combination of the size of the economy, the debt/GDP ratio, and the level of budget deficit or surplus, with the objective of allocating higher weights to the more fundamentally sound countries.