Sanctuary in the crisis
Emerging market debt has had a good crisis and is now firmly established in the mainstream. But, as Joseph Mariathasan finds, the complex matrix of exposures it represents raises the question of whether it is one asset class or many, and demands a properly considered allocation process
The global crash may have illustrated the fact that emerging markets are deeply interlinked with the developed world, but the emerging market led-recovery suggests that their structural and sustainably higher growth rates are indeed decoupled from those of the developed world. Moreover, emerging market debt (EMD) has shown surprising resilience throughout the crash.
“The world has been through the most severe crisis since the Great Depression and EMD has been a total bystander in this,” observes Mike Conelius, head of EMD at T Rowe Price. “There has been not a single significant sovereign default except for Ecuador, which chose to stop servicing two bonds for reasons not at all attributable to the financial crisis. On this evidence alone, EMD is safer than it has ever been.”
Imran Hussain, a managing director within BlackRock’s fixed income group, even suggests that some time during the next few years, there will be a fundamental reassessment of the relative riskiness of the developed countries versus the emerging in favour of the latter. The much-enlarged IMF now provides an additional backstop at the sovereign level.
On the technical side, while Kristin Ceva, managing principal at Payden & Rygel, concedes that investors are perhaps more likely to add exposure to equities and corporate bonds after last year’s sell-off, she observes that investing in a country is different from investing in a corporate: it offers diversification benefits, while sovereign default rates are expected to be much lower than US high yield (less than 1% versus 4% by July 2010). Indeed, the EMD market remained open and liquid except for a brief period in October and November 2008 This situation is very different from the high yield sector that it used to be lumped in with. No wonder EMD managers like John Morton, head of EMD at Rexiter Capital Management, argue that, on a GDP-weighted basis, developed market institutional investors’ allocations to emerging markets are insufficient, and will at least double within the next five years.
It seems perfectly reasonable that emerging markets should, by definition, experience higher growth rates on average than developed markets. The main exception to this common-sense rule was the 20 years after 1980 to 2000, which in itself is interesting. “The culprit here was the sharp cyclical worsening of EM balance sheets at home, with widespread over-leverage, excessive debt, heavy government borrowing and external deficits,” explains Jonathan Anderson, an economist at UBS. He argues that the real guarantee of future decoupling is not that the emerging world is any more insulated or less exposed to global trade than before, but that emerging economies have experienced a striking and widespread improvement in domestic balance sheet fundamentals, allowing them to grow more rapidly at home during any given point in the cycle.
“The improvements seen in emerging markets during the last decade have been primarily at the sovereign level and you would be hard pressed to find similar structural improvements at the corporate level in areas such as good corporate governance,” argues Alex Kozhemiakin, director of emerging market strategies at Standish Mellon. “Sovereign debt is very attractive as it offers a clean exposure to the improved macro fundamentals of emerging market economies without extra company-specific risks. Sovereign debt is also more liquid than corporate issues.”
Dollar-denominated debt used to offer the best exposure. The financial crash and the flight from risk led to a sharp widening of spreads over US Treasuries, but in recent months spreads have tightened to pre-Lehman bankruptcy levels and hard currency debt should now arguably be seen as a lower-risk, lower-return asset class next to the ever-increasing local-currency issuance on the market.
“Local-currency debt will dominate EMD in the future both because spreads in hard currency have gone to very low levels, and also because future issuance of EMD will be predominantly in local currency,” says Simon Lue-Fong, head of EMD at Pictet Asset Management. Since 2002, local currency debt has risen from less than 40% of the total market value outstanding to more than 75%, based on JP Morgan indices. In the first half of 2009, $47bn was issued, beating the $36.7bn total for 2008.
The two drivers of local-currency debt return can be managed completely separately using FX and interest rate derivatives to hedge out (or gear up) currency or duration sensitivity as desired. Many assume that emerging market currencies are likely to appreciate against the dollar over the long term. Relatively high local bond yields provide an additional source of return - and in many countries the level of local yields is primarily a function of local inflation expectations rather than creditworthiness.
The positive term premium embedded in local yield curves generally makes government debt a more attractive way of getting emerging market currency exposure than currency forwards. Currency forwards do enable bond managers to invest in countries where the currency is attractive but not prospective duration returns, however. “Most local currencies are still 10-15% weaker than they were 12 months ago and we expect the persistent growth differentials between EM and G3 to continue serving as a magnet for capital flows into emerging markets,” Kozhemiakin says.
As Hussain points out, in 2007 and 2008 there was a massive repricing of debt in advanced economies, and longer-term the US must find a new engine for growth to replace the exhausted home-grown consumer. The natural path is dollar depreciation - which will no doubt be helped along by the increasing questioning of the dollar’s status as the global reserve and safe haven. New growth will arise from consumers in emerging economies and, as a result, there are structural pressures for appreciation across a swathe of emerging markets. “We are strong believers in the need of a global rebalancing and emerging markets will be at the forefront of that, leading to stronger Asian currencies and a weaker dollar,” says Michael Gomez, co-head of emerging markets portfolio management at PIMCO.
Inflation-linked local currency debt is available in many markets (Asia has little coverage beyond a small issuance from Korea, and they tend to be less liquid than nominal bonds everywhere except Chile), since central banks throughout emerging countries have focused on controlling inflation. “In 70% of the JP Morgan local index, the central banks have inflation targets,” says Lue-Fong. “This makes the predictability of monetary policy much higher and as result, risk premiums shrink.”
Still, opinions on how effective countries will be at controlling inflation is mixed and managers can take advantage of a more pessimistic view through the inflation-linked market. “The breakeven inflation level in Poland is just 1.5% over the next five years and 1.8% in Chile, whilst in Turkey, it is 3.6% when the target rate of inflation for the central bank is 7.5%,” says Peter Eerdmans, head of EMD at Investec Asset Management (who held 16% of his portfolio in inflation-linked EMD in mid-September). “With a big rally in nominal bonds, inflation-linked bonds had lagged a lot, giving us a great opportunity to buy, and providing us with a hedge when and if inflation starts to go up.”
Initially, EMD fund managers reacted to the increased prominence of local currency bonds either by including them as an out-of-the-benchmark allocation in traditional US dollar portfolios or by switching to blended benchmarks. Sometimes local currency bonds can be a better way of expressing a view. “We could be underweight a country in terms of their dollar bonds because their credit was weak and spreads could widen,” explains T Rowe Price’s Conelius. He currently has 80% in hard currency and 20% in local currency. “But if their economy is weak and the currency is tied to the US dollar, as in the case of Mexico, for example, local bonds should do well as local rates go down. We like the currency for the same reasons that we don’t like the credit. We currently have more confidence in rates and we did not want to double risk by adding in a currency exposure to, for example, our investment in Brazilian bonds.”
Cathy Hepworth, head of EMD at Pramerica also includes hard and local currency bonds within a single portfolio, but while she has a hard currency benchmark, she can have up to 30% in local currencies, but currently only has 6%, holding the view that it is not clear when central banks will start raising interest rates and, in the meantime, the yield pick-up only outweighs the short-term currency risk in a few cases.
Combining local with hard currency exposure in this way against a hard currency benchmark is a natural progression for fund managers - not least because the opportunities in hard-currency debt has reduced dramatically as spreads tighten and off-benchmark positions are starting to add more value. But investors might be better served by making explicit recognition of the local currency as a separate asset class and awarding mandates to managers on that basis as a result of their own analysis of their strategic asset allocation. The creation of local currency indices gives investors the tools to do this.
Kozhemiakin argues that while both dollar-denominated debt and local currency debt will act as diversifiers within a portfolio, their behaviour will be different and a random mixture would not be easily modelled within an ALM study. “There is little evidence to suggest that managers can add alpha through tactically switching between the two asset classes within a portfolio, but instead, are more likely to introduce an added and unnecessary layer of complexity and possible confusion,” he warns. This is also Lue-Fong’s view, but he concedes that end investors are not necessarily in a position to decide how they would like to split their allocation, and many clients end up asking Pictet to split the exposure equally.
Emerging market corporates also issue debt, of course, and that market looks set to evolve thanks to the fact that these companies are beset by the same liquidity squeeze that dogs US and European issuers, as Western banks dial down their syndicated loans. “These companies are in good shape and less leveraged than US high yield issuers,” says Conelius. “They also have access to government funds either directly or through government banks.”
Corporate bonds can be a way of leveraging fixed-income capabilities off of equity research. Credit analysts are organised across global sectors, as most of the companies being looked at are in sectors such as energy or steel, which have global markets. “But even in banking, very much a local sector in emerging markets, there can be value in having banking specialists comparing banks in Nigeria versus Kazakhstan, rather than just a country specialist,” says Conelius.
Further down the corporate risk spectrum lies a world of opportunities perhaps more attractive to hedge funds than institutional mandates. For example, Jason Manolopoulos, managing director at Dromeus Capital, manages a fund, launched in July 2008, that has a large exposure to local currency corporate debt alongside sovereign debt and currencies. He focuses on local currency corporate debt in Central and Eastern Europe, relying on a team with local knowledge and networks to be able to cope with the numerous issues that arise. “There are lots of difficulties in the legal structure,” he says. “For example, in Russia there are no trustees, so every bond holder has to act on their own. There are large pick-ups in yields on local currency corporate debt, but you are being paid for the illiquidity and the corporate governance risks.
“Whilst the easy money has now been made in the bond markets, with spreads on investment grade and high yield having come back down to more normal levels, there are still lots of opportunities in distressed debt. We have three or four special situations. The potential returns are so high that it is worth the effort.”
Such transactions which rely on arguing the case for bond holders against other stakeholders in the business may be very successful at times - with bondholders being repaid in full and equity holders sometimes getting thrown into jail - but might be strong meat for most institutional investors. Not surprisingly, Dromeus’s investors are mainly family offices and high net worth individuals such as Greek shipowners. But the broader EMD world is clearly now a mainstream set of very different asset classes and risk profiles. Indices such as the JP Morgan set and the newer Markit iBoxx GEMX have been developed to provide pragmatic benchmarks for investors to be able to monitor and define the universe of investments for fund managers. But there needs to be an appreciation that the spectrum of investment choices within the EMD universe is now so diverse that EMD cannot be regarded as a single asset class, and both fund managers and investors may need to reassess how they include the different sub-classes within their portfolios and how best to award mandates to managers.