Currency weakness in emerging markets against a strong US dollar has tended to give a misleading picture of the potential opportunities in the asset class, writes Joseph Mariathasan
Local-currency emerging market debt (EMD) has been a disappointing asset class over the past few years because of currency weakness in emerging markets against the strong dollar. Yet it is also too large to ignore.
“The future for sovereign issuers will be in their local currency markets in the long term,” says David Dowsett, joint chief investment officer and co-head of EMD at BlueBay Asset Management. He argues that, on a 10-year view, local currency corporate debt will enjoy the strongest growth.
The opportunities within the asset class are arguably still badly served by index providers. Sticking closely to an index, even when weights are capped at 10%, is an absurd way of managing risks and opportunities. As Jan Dehn, the head of research at Ashmore Asset Management, says, the implicit assumption is that the benchmark is the minimum risk position, even if it is concentrated in a few countries.
The huge advantage of local currency debt, as Sergio Trigo Paz, the head of EMD at BlackRock, argues, is that local debt in any portfolio is a big diversifier of returns. “Dollar spreads in hard currency debt are highly correlated to risk on/risk off movements in the marketplace, whereas local yields are totally independent of this,” he says. “As a result, most institutional clients need to have a high exposure to local currency debt.” But, he adds, the foreign exchange (FX) component accounts for 75% of the risk. It is very directional, as it is vulnerable to a strong dollar. One approach, therefore, is to get exposure to local yields but reduce the FX exposure by hedging local currencies into hard currencies such as the yen and Australian dollar. The latter is a good diversifier given its commodity exposure.
At a glance
• Conventional indices substantially understate the importance of local currency debt in emerging markets.
• The local corporate debt market is becoming more accessible to foreign investors.
• China’s debt markets are also in the process of liberalisation.
• The usefulness of conventional local currency indices is being called into question.
A problem for investors using the main benchmark is that it is dominated by a small number of countries, with each capped at 10%. These include Brazil, Malaysia, Mexico, Turkey, Poland and South Africa, while Russia has a 9% weighting. Simon Lue Fong, the head of EMD at Pictet Asset Management, points out that long-only managers, who are obliged to stick closely to the index, will be obliged to have exposure to Brazil and Russia even when they are negative on their prospects. Conversely they will have no exposure to China or India, which have enormous local-currency sovereign debt markets, as are left out of the indices owing to their lack of market accessibility.
Two key factors are likely, over the course of time, to dramatically increase the opportunities in local-currency debt. The first is the local-currency corporate debt market, which is comparable in size to the sovereign debt market at over $5trn (€4.6trn). Dehn argues that index providers and investment banks have both downplayed its size. “The two are related, since many investment banks are producing specialised indices that just reflect the universe of bonds they are willing to trade,” he says. “There is only one index – the Bank of America Merrill Lynch, representing a market cap of $110bn, or 2% of the universe. Yet long-term institutional investors should be willing to take illiquidity if they are compensated by extra returns.”
At present, however, as Grant Webster at Investec Asset Management points out, much of the $5trn of local currency corporate debt will be inaccessible to foreign investors. It will be privately held, issued in small size to the local banking and insurance sector, or come in the form of structured loans. “Thus the accessible portion is much smaller than one may think, especially given the size of the asset base trying to access it, and thus the accessible liquidity premium might not be as attractive as one might hope,” he says.
“The future for sovereign issuers will be in their local currency markets in the long term”
BlueBay’s Dowsett also points to the challenges of onshore settlement and the difficulties arising from being subject to local bankruptcy laws. As most of the debt is short duration and sold to the local banking community with a buy-and-hold policy, liquidity is also a severe issue. However, Dowsett adds: “That is all beginning to change. There has been more issuance from the Turkish banking community, as well as from corporates in Russia, Mexico and Brazil. There has also been a great deal of issuance from Chinese corporates which, though, do have risks arising from a lack of visibility, whilst in Russia there are issues of corporate governance.”
The second major development is the opening up of China’s domestic debt markets. The total size is $5.7trn, with government bonds accounting for about 30% of the total outstanding, according to the credit rating agency Fitch. The government bond market is only surpassed in size by those of the US and Japan. As Hayden Briscoe, the head of Asia Pacific fixed income at AllianceBernstein, points out, this means that once China is allowed to enter the major indices, it alone would represent 13% of a typical global government bond index.
Pictet’s Lue Fong argues that China’s markets would have to open up a lot and remove the quota systems before entry to any index could be contemplated. But China has already begun that process with the removal of quotas for central banks, sovereign wealth funds and supranationals.
Fitch says these reforms will help facilitate the Ministry of Finance’s local government debt-for-bonds swap programme. This aims to lower the financing costs of local governments by converting high cost debt into municipal bonds. AllianceBernstein’s Briscoe says the municipal bond market in China will be an increasingly important investment opportunity for foreign investors. Fitch maintains that Chinese local government bonds will continue to benefit from an implicit sovereign guarantee. Fitch regards the scale of the debt swap as so large that demand from onshore investors might not be sufficient to meet the substantial increase in government bond supply. As the rating agency notes, a large proportion of local government bonds thus far are held by big commercial banks.
“There is a European bloc that includes emerging Europe, an Asian bloc dominated by China and a US sphere that includes Latin America”
The take-up from other onshore investors has been relatively limited. Therefore, opening the interbank bond market to foreign investors will help to diversify the investor base for the local government bond market at a time when significant new supply is coming.
For many investors, onerous capital controls prevent greater exposure to China’s domestic debt markets. But Briscoe sees a potential complete liberalisation of the capital account for institutional investors within a year. “The impact on indices would be transformational,” he says. “Our view is that it would destroy the rationale for the existing structure of local currency emerging market debt indices.”
Briscoe points to the disparity between China’s status as an emerging economy, as measured by GDP per head, and the strength of its domestic bond markets. They are both larger and more highly rated than most developed markets.
Indeed, Briscoe argues that it is time to move away from the concept of global emerging market debt strategies as global trade has become much more regionalised. “There is a European bloc that includes emerging Europe, an Asian bloc dominated by China and a US sphere that includes Latin America,” he says. This insight points to the longer-term evolution of local currency debt markets.
Stuart Sclater Booth, portfolio manager at Stone Harbor Investment Partners, says that in the shorter term, China, and eventually also India, will enter the emerging market diversified indices on the same capped basis as other large markets. “Where it may certainly have a larger impact will be in global government bond strategies where it will divert allocations from peripheral markets and from European countries,” he says.
The role and importance of local currency debt is growing rapidly. Looking at past performance of the benchmark indices gives a misleading impression of the risks and rewards available for active investors who are not benchmark constrained.