Emerging market debt (EMD) has certainly hit the headlines in recent years. Argentina defaulted in 2001; in January 1999 in Brazil the real was devalued by 40%; Russia restructured its debt in 1999, while in 1997 the Asian crisis saw a collapse in investor confidence spread among the region’s countries. Yet, according to Jerome Booth at Ashmore Investment Management, “the really big story is that virtually all pension funds will have an allocation to emerging market debt in 10 years’ time” .
EMD is mired in confusion and prejudice and as a result, despite being one of the best performing asset classes over the past 12 years, institutional investors have been wary of investing. The future demand will, however, reflect the maturing of the sector from an era with no investment grade credits to the present, where over 40% of the universe is investment grade. “EMD has changed from a hedge fund/proprietary driven market to an institutional marketplace where it will remain,” says David Dowsett of Bluebay.
Kristin Ceva of Payden & Rygel argues that now “EMD is seen much more as a continuum. It is difficult to talk about EMD as a separate asset class. There are so many different ways that it can be used”. However, the 25% returns seen in some years in the capitalisation weighted indices are unlikely to be repeatable, according to Jeff Kaufman of Putnam. “During the last 10 years, returns were from dollar denominated bonds. In future, to have any chance at that sort of return, you need to go progressively into more risky assets with much more downside, you need to go into local currencies, areas such as Chinese non-performing loans, etc. They may work out well eventually but are a different universe to the one that generated the attractive returns of the past.”
EMD is a transitional asset class and Ashmore’s Booth points out that “during this transition (towards developed market status) major paradigm shifts can be identified which have fundamentally changed the investor base and underlying dynamic of the market”. This is reflected in the different segments within the market – bank loans, Brady bonds, euro-bond issues and local issues.
The 1983 Mexican crisis led to a more liquid secondary market in loans. The Brady plan of the late 1980s and early 1990s, was a response to the developing country debt crisis of the 1980s, and consisted of a combination of stick and carrot offering reductions in loans outstanding in exchange for significant changes to the fundamental problems of the debtor countries, such as protected markets and controlled prices.
Commercial bank loans to private, semi-private and sovereign entities were transformed into sovereign bonds, with a portion collateralised by high quality money market instruments and Treasury zero coupon securities. This introduced huge liquidity but according to Booth, “a third of it was leveraged, and it brought in contagion”. Foreign denominated bonds have been issued by developing countries for at least 100 years. In more recent years, their credit record has been excellent even during the bank loan crisis and defaults. They tend to form a continuum with the Brady bonds.
A number of countries have liquid local markets in debt, which tend to be short term, as a result of the historical high inflations rates, with longer term debt denominated in dollars. This has historically been of less interest to most fund managers in EMD except for the specialists such as Ashmore, requiring systems and local expertise. Booth says: “Local currency debt is the least risky. There has been a positive skew, a shorter duration. It is a better credit quality than the dollar.” Foreign currency denominated corporate debt, mainly dollars, is also of interest although these are much smaller sizes and tend to be much less popular. Julio Delgado of T Rowe Price explains their view as: “We don’t buy corporates. They don’t pay you. The spread difference is small and you are taking on the specific risk of the company.”
JP Morgan offers the most comprehensive group of emerging markets debt benchmarks, whilst Lehman Brothers and Citigroup Global Markets also support emerging markets debt indices, each with its own idiosyncracies. There is, however, a fundamental philosophical and practical problem with any capitalisation weighted bond index that leads many to question their usefulness at all. This is that, unlike an equity index, the amount of an issuer’s debt represented in a bond index is not very sensitive to the market’s pricing of its debt. The credit spread forms only a small part of a bond’s yield, except for high yield or distressed debt portfolios. As a result, we have the perverse result that the weaker an entity becomes financially through the issuance of more debt, the more an index will weight that entity, even though its attractiveness is reduced.
This was illustrated in a spectacular manner with the default at the end of 2001 by Argentina of $2.9bn of debt. Up to the actual time of the widely predicted default, fund managers who stuck close to the JP Morgan Emerging Markets Bond Index Global (EMBI Global) were taking on more relative risk by reducing their exposure to Argentina.
Risk concentration was tackled by the introduction of the EMBI Global Diversified index, which limits the weight of index countries with larger debt stocks. It still leaves a key problem with any EMD index that they do not give any indication of credit beyond eliminating any countries that graduate to a single A or above.
Credit quality has been consistently rising since 1997. “Investment grade was 27% in 1999 and became 45% last year when South Korea was in and is now 42% in the MB global diversified.” Greg Saichin of Pioneer says while “at some stage Argentina will do a deal that most investors are happy with. At that stage, they will be back in the index and if they are back in the index even with a single B, lots of funds will have to buy it and the overall credit quality of the index will go down”.
The transformation of the EMD market over the last 12 years towards a mainstream component of any global fixed interest strategy has been driven by two key effects: firstly the general increase in credit quality, and, secondly, the elimination of contagion.
The chart shows the gradual progression of countries up the credit spectrum that has occurred. Does this mean that “once countries get investment grade rating, eg, Russia, Turkey, Brazil, the asset class will disappear?” asks Kaufman. “It would be a wonderful problem to have and a 10-20 year process. Similar to the EU convergence that gave zero spreads to bunds for Spanish and Italian bonds.” The question is , can you keep getting upgrades?
Kaufman points out that “in the last year, there were many more upgrades than downgrades. The trend is that way. Now is the first time that Latin American countries are introducing counter-cyclical policies. The first time that the primary fiscal surpluses are staying high when borrowing is easy for countries”.
Michael Conelius and Fiona Leonard of T Rowe Price also point out that several emerging markets are on a convergence path which is appealing from an investment standpoint. “Most of eastern Europe has an active ‘accession path’ to the EU under the Maastricht criteria. Mexico and some central American markets are moving closer to the US under the guidelines established in NAFTA”. Such an accession path “narrows the range of policy choices (ie, mistakes) that emerging market governments can take”, which ultimately leads to higher ratings.
The idea of contagion is indelibly imprinted in the minds of any potential investor in emerging markets. “Just recall the 1997-1999 liquidity crisis that erupted in Asia (with
both Korea and Thailand requiring massive IMF support to avoid a default), moved to eastern Europe (where Russia defaulted), jumped
to Latin America (forcing Brazil to abandon its fixed currency regime), and almost spilled over again to Asia threatening a second round of global instability,” Mohamed El-Erian of Pimco recalls.
Why should contagion be less of an issue going forward? The first reason is the transformation of economies driven by not only better domestic policies, but also by a surge of commodity prices driven by the structural increase in demand from China, and the cyclical recovery in the developed economies. As a result, El-Erian says, “international reserves have surged to record levels in several emerging economies”.
The second reason, according to Booth, is that the market has matured from the period when “problems in Brazil meant markets thought there were problems in the Philippines. This is collectively irrational!” He argues that “the Russian crisis removed leverage. The consequence is that we now have a market with single digit volatility despite the fact that since 1998 there has been a devaluation in Brazil, and a default in Argentina”.
There are a number of approaches to investment in EMD. What is likely to be the largest in the next 10 years is through ‘cross-over’, where managers with investment grade bond mandates are allowed to diversify risk through incorporation of investment grade emerging market debt. Dedicated long only investment in EMD can be done either through an index aware strategy, or through an absolute return approach that ignores any index constraints. Finally, the most unfettered approach is through specialist hedge funds that are able to go short and to use leverage.
Most bond managers with wide mandates are increasingly likely to incorporate EMD in so called cross-over investment. Kristin Ceva at Payden & Rygel for example says: “Most of what we manage is cross-over. When I started, seven years ago, most people used EMD in dedicated mutual funds or in core plus portfolios. As it has become much more investment grade, we can use it in many different strategies. For example, short duration accounts, global high yield accounts. We use EMD as an adjunct in portfolios seeking to outperform Lehman indices.”
The traditional approach for actively managing any asset class is by taking positions relative to an index. Despite the flaws in the philosophy behind bond indices, this is still a popular approach for EMD managers. Kaufman argues strongly that such an approach makes more sense in the new ‘Double-B’ environment of average credit quality and with the introduction of the EMBI Global Diversified index which eliminated the ‘Argentina’ problem seen in earlier completely capitalisation weighted indices.
“Benchmark-aware managers with defined risks should be able to deliver the desired benefits more dependably.” Citigroup Asset Management, one of the largest EMD managers, follows the approach where, according to Paul Timlin, “we construct our portfolios to try to outperform the returns of the chosen benchmark while matching the benchmark’s volatility as closely as possible”.
For such managers, as Kaufman explains: “Rather than relying merely on a broad market-rallying trend to do well, we look to outperform the benchmark whether the market is rallying or selling off.” He argues that “ignoring the index often means taking on more than market risk. By buying only the highest yielding bonds with the highest return potential, many managers are exposing their clients to greater downside risk than they may appreciate. Managing to a benchmark is really a way of circumscribing this.”
He goes on to add: “When the average rating was B and spreads were very wide, the strategy of high beta was okay. Now the average credit is BB and spreads are much tighter. You can’t rely upon 300bp of spread tightening to generate overall return any longer. The most dependable way of getting excess return is by picking the right countries whilst limiting the potential damage in a crisis. That’s what EMD should be in a BB world.”
Managers such as Ashmore, who focus solely on emerging markets, disagree strongly with the whole concept of measuring risk and returns against a benchmark composed of existing bonds. “The available benchmarks are much riskier than our funds and more concentrated,” complains Booth. Such managers seek extra-ordinary returns by seeking extra-ordinary value wherever they can find it.
Booth argues passionately that “spread contraction is a permanent source of return. The index is irrelevant. It’s a wrong way at looking at a huge growth rate in the market. Historically the tradeable market capitalisation was increasing at 13% annually and now it’s even higher. Increased debt reflects increased credit ratings worldwide. Moody’s used to have 77 countries that were vulnerable should they be cut-off from capital for 12 months. Now that list is less than a dozen. The nature of developing countries is that productive capacity is lying idle because of a lack of access to capital. This can be brought into use with access to capital at typically anything below 15-20%.”
Ashmore adopts ‘a bar-bell’ approach and seek two sources of excess return, one is from a top-down macro view and the second through special situations. In their main fund 80% is very liquid while the rest would be special situations such as “going into an Indonesian company with holding company problems but strong cash flow. Then we will take a controlling position in the debt and move the company to restructuring – this could be six months or up to three years”.
GMO is also a value investor in EMD, but its approach is to look at off-the-run issues, sacrificing liquidity for extra yield and controlling exposures through the use of credit default swaps. This can work very well but runs the risk of being stuck with a large unhedged exposure in crises such as that of 1998. As Booth points out: “If you want less risk in the Brazilian context, it does not mean can I get out in six months rather than two years, but rather can I get out today. We can completely change the risk profile in a morning.”
Some firms have tried to change their approach with the change in the market. Pioneer’s strategy “moved from an index tilt fund in 2000” to now “trying to manage as a total return fund, concentrating on the winners and ignoring the losers. In a time of low spreads, we see very little point in investing in countries with low upsides. This favours lower credits”.
A number of firms, including Bluebay, manage EMD on both a long-only basis and in hedge fund mandates where, for example, for every $10m invested, they go long of $20m of debt and short of $10m.
Shorting of EMD exposure according to Bluebay’s Dowsett, “can be undertaken through going short of the actual bonds, using credit default swaps and through the use of options on bonds and on indices”. Bluebay’s hedge fund has eight-10 credit views and risk is controlled through both “formal risk models such as value at risk analysis, although we prefer to look at risk on a forward-looking basis using a lot of scenario analysis”, Dowsett explains.
For institutional investors, Payden & Rygel’s Creswell sums up the future: “The market is dividing into two directions. Some EM specialists, and some of our mandates, may permit us to invest in below investment grade credits. In these areas there is potential for periodic high returns. But the structure of the whole market is changing. People are seeing that they are getting a better risk-adjusted coupon. A large proportion is investment grade. It is worthwhile having some of the asset class for the above average coupons.” It’s a view that the majority of the fixed interest market will come to accept.