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EMD overcomes credit concerns

merging market debt (EMD) is a fascinating asset class given the rise of the emerging markets as major economic powers in their own right, a trend most notably discussed by Goldman Sachs with their BRIC (Brazil, Russia, India and China) hypothesis.

But it is not just the BRICs that are important. Indeed, critics of Goldman Sachs have added that Countries in Emerging Markets Excluded by New Terminology (CEMENT) is needed along with BRICs to construct robust portfolios. Opportunites in EMD encompass 30 or more countries with over 40% of the investible universe in the major indices now investment grade.

While the US sub-prime mortgage debacle provided a severe test for all the global debt markets, causing a massive widening of risk premiums, Ece Ugurtas, director of fixed
income and currency at Baring Asset Management, points out that EMD was relatively unscathed in the
August sell-off and became something of a safe haven. "Bonds were largely unaffected with currencies bearing most of the hit. Emerging market currencies have since recovered past their previous levels to multi year highs."

Corporate debt markets were virtually closed to new issuance for many weeks and the fact that the first entity to issue since August has been an emerging market is a testament to the asset class as a whole, and a reflection of the fact that it has essentially become a mainstream investment choice for any major fixed income manager.

Perhaps the key hurdle that EMD is steadily overcoming is the preconceptions of investors on the relative credit worthiness of developed and emerging markets, and the dynamics of the changes in credit ratings that are occurring.

The downgrading of Italy last year to the same level as Botswana is a reflection of the strength of the credit ratings of many countries that have not registered at all on the consciousness of most investors rather than purely being an indictment of Italy.

As Jerome Booth, head of research at Ashmore, says: "Russia is a much better creditor than Italy. If you look at the probability of Italy leaving the euro and the likely consequences, it is easy to see that." Kristin Ceva, EMD portfolio manager at Payden & Rygel, adds: "Most people expect that Brazil will be investment grade in next few years, while other BB countries such as Peru and Columbia will be investment grade in the next couple of years."

Lori Whiting, EMD product manager at Pimco, says: "While spreads have narrowed for the asset class overall, that spread compression has come along with a significant increase in the economic health. We expect the improvements in economic and fiscal policies in many countries to have a long-term impact and therefore expect to see continued ratings upgrades for many - but importantly not all - emerging market countries. The trend has continued apace over the last couple of months even as credit markets experienced extreme volatility with upgrades in Brazil, Uruguay, Mexico, Colombia and others.

"As countries continue to move from B to BB, BB to BBB, spread compression is also likely to continue. In addition, the external debt buybacks, that some fear may signal the end of the asset class, provide a strong technical tailwind to spreads for those countries where this is expected to continue."

Ugurtas also points out that if you compare Mexico relative to the US in terms of growth, inflation, current account deficit and budget dynamics - Mexico has higher growth levels than the US, slightly higher inflation but on the latter two measures, the US is in negative numbers, whereas Mexico has a very small current account deficit, a balanced budget and it has one third of the US in terms of public sector debt. With Mexico yielding 8% on its 10-year bonds and the US yielding 4.5%, it is not surprising that bond managers are seeing very attractive opportunities in specific emerging markets.

The market has also grown vastly more sophisticated in its analysis, leading to the elimination of the contagion effects seen in emerging markets during the crises in Mexico in 1994 and Russia in 1997.

"If you are Brazil - with double the reserves of the US, inflation less than 4%, a great current account surplus - you are invulnerable to foreign shocks. It is a good time to issue more local currency debt," says Booth, and with many other countries also enjoying better statistics than the US, it is not surprising that the rise of local currency debt markets will remain a dominant theme for years to come.

As Jim Craige, EMD portfolio manager at Stone Harbor points out: "Most countries don't have a financing need and to the extent they are developing local currency market, it will cause the dollar debt market to reduce. There is not much sovereign debt issuance and it tends to be a device to establish a benchmark yield curve."

Indeed, for Ugurtas, "hard currency external debt is a dying asset class. I don't think it will exist in five years' time. Most countries are buying back their external debt and replacing it with local." This may be a controversial view. Booth observes: "Turkey is issuing debt. Ghana is issuing its first ever bond," he says. It is also clear that the hard currency market has been completely overshadowed by the rise of local currency markets and Booth himself points out that a lot of new paper is being issued. "The tradeable size of EMD is $5.5trn (€3.9trn). It went up by 25% last year and 29% the previous year. All of that was in local currency debt," he says.

Rather than agreeing that hard currency debt as an asset class is dying, Whiting would rather describe it as "changing and evolving". She goes on to add that since this evolution is ongoing and far from over, Pimco believes that many attractive opportunities still do and will continue to exist in emerging market hard currency markets.

"While new sovereign supply is declining, new sources of supply continue to deepen the hard currency debt market," Whiting continues. "In particular, corporate debt issuance is an increasingly important segment of this market as the acceptance of emerging market sovereign issuers by the international financial markets has allowed emerging market corporates to access funding via the bond markets. Corporates accounted for roughly 70% of external issuance in 2006, up from roughly one third five years ago. Finally, the rapid growth of the credit default swap market in emerging markets is also an important source of exposure to, and opportunities in, this market."

 

As fixed income managers increasingly incorporate EMD into global portfolios of all types, the issues for them and for their clients will be the level of resources they need in order to effectively incorporate local currency debt markets across 35 or more different countries. "We have been focusing on local currency since 2004 - one of the earliest houses to focus on that," says Ceva.

Many other global fixed income fund managers would argue that they are building up their resources since, as Booth says, "local currency debt is a separate investment theme offering a different risk/return trade-off. It has more explicit currency and interest rate exposures, with different exposures to interest rates, much shorter generally but coming out."

Indeed, Ceva believes that some countries have done a pretty good job building up local yield curves. "You can now get exposure to 30-year bonds in Mexico in local currency, whereas in the past you may have been able to go to five years. But now there is demand from local pension funds to build up local yield curves."

Booth adds that emerging market countries want to be like the G7 in the long term, "issuing in your own currency and so having more levers of control - you can inflate away or move the currency to change your liabilities. What people want in emerging countries are 30-year bonds at low interest rates but owned by local investors."

He goes on to make the point that US debt is over 40% owned by foreign investors which is why it is more risky than Brazilian debt. "Treasuries will continue to be volatile and the US dollar will be a risky currency. In Brazil, local investors are dominant in both external and domestic debt," he says.

 

The development of local currency debt markets has profound implications for EMD as an asset class and Craige sees it becoming a more normalised market: "Most countries will develop futures markets and yield curves will become established and benchmarks extended further out." But he goes on to add that for the market to develop there needs to be a better trading environment for settlement. "Some countries are easier to trade with than others," he says.

"You need to get to standardised settlement system based on a period of T+3, and delivery versus payment. In Indonesia, the only way you can get exposure is through a credit-linked note as there are so many restrictions in place. In Columbia, there are capital controls in place so you need to get a peso linked dollar bond, while in Brazil there is a 38bp transaction tax. Turkey is more fluid and easier to trade." For Craige, the ultimate objective is to be able to make investment choices "purely in investment criteria rather than having to consider settlement issues".

Local currency debt is not a panacea for investors or for issuers. The risks for investors, as Ceva points out, include the fact that liquidity in some countries is still less than in external debt. For example:

q There is potential for change in the regulatory environment, such as tax amendments and capital controls;

q Any shocks can be amplified by currency movements - the correlation between external and local debt increases in times of stress;

q There can be difficulties in hedging in certain countries.

Issuers can also face problems. As Booth says: "The appearance of 30-year dollar bonds under the Brady plan was a huge improvement because it reduced short-term balance of payments pressure in a crisis - one offshore investor sells to another in a crisis but there is no selling of FX associated with an exit - and if a country now goes to issuing local currency debt they are increasing their vulnerability to external shocks as any local currency denominated investment can see sellers putting downward pressure on the currency as they exit in a crisis."

As a result, local currency debt may not be appropriate for countries with no early prospect of developing a strong domestic investor base, such as much of sub-Saharan Africa.
The countries need more debt, adds Booth: "The corporate sector requirements for debt are 10 times the government sector but it needs a sovereign debt yield curve to
price off."

Defining the most appropriate benchmark for an EMD manager has always been a problem. Some would argue that the whole concept of a capitalisation weighted index for bonds is misguided - in contrast to equity markets, the weaker an entity is, the more debt it is likely to issue.

Argentina in 2001 was 20% off the widely used index and naïve managers sticking to a supposedly low risk index tracking position would have been very badly burned in the subsequent default.

The rise of local currency debt has led JP Morgan to produce local currency indices, but portfolios are typically a blend of hard currency and local. As a result, Stone Harbor, according to Craige, finds that its clients are opting for a blended benchmark, 75/25 hard currency to local, or even 50/50. "All clients allow use of local currency and some want it as part of the benchmark, so we are blending benchmarks, In three year's time we would expect all our portfolios to have a blended benchmark," he explains.

Perhaps the real question is whether EMD should be regarded as a single asset class or as several, given that the term encompasses hard currency debt, local currency sovereign and quasi sovereign debt, inflation-linked bonds, local currency corporate debt that is still seen as a step too far by most managers, and a wide variety of distressed debt and private equity related loans, quite apart from the increasing quantity of derivatives that are becoming available.

The trend towards ‘global alpha/domestic beta', where fixed income managers attempt to beat local benchmarks by incorporating off-benchmark bets across a global spectrum, will invariably mean that more and more fund managers will seek to incorporate EMD into their portfolios without necessarily having deep resources to explore the deepest corners of the marketplace.

Some managers may incorporate hard currency investment grade debt from many emerging countries as part of their overall global investment grade portfolios without necessarily devoting specialist resources to the asset class. But Booth says that at Ashmore EMD is certainly a separate asset class. "Asset classes are defined by requiring a different analysis with different risk/return characteristics," he says. "External debt in emerging markets is definitely a separate asset class. While some managers would try and cover everything, they would not have any knowledge of emerging markets and the only way they can cover it is through an index."

Barings has taken this logic even farther and has an emerging market income fund that invests in debt, equities and currencies, although the current exposure to equities is zero, according to Ugurtas. But there are clearly interesting questions as to the level of resources and specialist expertise required to incorporate EMD into a portfolio, particularly when it comes to local currency debt.

Constructing EMD portfolios is a combination of country selection, stock selection and currency views. While it is sometimes possible to separate the country and currency views from stock selection, this is not always practical.

 

As Ugurtas points out: "Emerging market currencies are very important as they can be very volatile, often eliminating any bond market gains that may have been achieved. Sometimes, if you are negative on the currency and short-term rates are considerably higher than in developed markets, hedging currency risk becomes cost ineffective. For example, in Turkey short-term interest rates are 17.25%, hedging the currency would cost you 12.5% from a dollar base. With long dated Turkish bond yields of 15.5%, your net yield post hedging is just 3% making it unattractive to invest on a currency hedged basis. So if you don't like the Turkish lira, you probably shoudn't be owning the bonds."

Undertaking country analysis is a combination of both quantitative analysis and also qualitative analysis. Stone Harbor, for example, has a quantitative analysis for country selection that focuses on cash flow analysis, asking whether the country is generating sufficient cash flow to service its debt. In the case of balance sheet analysis, it asks whether the country has the borrowing capacity to meet a cash flow shortfall and growth analysis and also whether the country's economy is growing at a sufficient rate to improve its debt servicing capacity. The firm believes that the key to successful sovereign credit analysis is "determining the relative importance of each of these factors over a given time period".

Qualitative analysis is predominantly analysis of the political risks and set-up within different countries focusing on political change. "Elections often impact the direction of credit quality, currency valuations and the levels and direction of portfolio and trade flows; the impact of reforms on investment through monitoring foreign direct investment and portfolio flows; the consistency of central bank monetary and exchange rate policies; the degree of central bank independence; the structure and development of the local market and the market technical factors including liquidity concentration as well a anecdotal
evidence of investor position," the firm says.

After selection of a country, picking bonds requires a lot of analysis. "How much real risk are we taking in each country - two year versus 30 year bonds?" asks Craige. "If we have a 10% allocation to Brazil, if it is all in the 25-30 year bonds it has three times the risk of the five year. What is important is spread risk duration. If you want to buy Brazil, just buying the most liquid bond leaves money on the table."

"Globalisation means capital is flying to parts of the world offering higher returns. But arguably, there was more globalisation a hundred years ago than now," states Booth. "The anomaly today is that the emerging countries are massive net creditors. Asia, Latin America and OPEC are consciously increasing reserves by buying more dollars to produce export-led growth so they never have to go to the IMF again."

But this situation is unsustainable in the long term, for example, as seen in the build-up of China's massive trade surplus since 2005. This has fuelled an export-led GDP growth boom at the expense of domestic consumption and a lack of domestic demand driven by factors such as inadequate healthcare and education provision, poor income growth, restrained government spending and an underdeveloped financial system according to Mark Williams, an economist at Capital Economics.

"FX sterilisation with double-digit interest rate becomes expensive and enough is enough," adds Booth. "But as soon as they stop building reserves, the currency goes up by 30%. This has created low inflation stability and enables private investors to make long-term decisions. So again, good for infrastructure projects in emerging markets."

 

Williams forecasts 10% renminbi appreciation both in 2008 and 2009, halting the growth of the current account surplus. Financial sector reform, leading to stronger wage and income growth and increased deficit spending, will give a direct boost to demand, promoting household spending. Transitional issues in Asia generally, as countries shift way from export, will cause areas to feel pain. "That will generate opportunities for distressed debt, so whichever way you look at it, there will be more local currency debt," says Booth.

Perhaps for any bond investor dealing with the aftermath of low developed market bond yields driven to a great extent by the activities of emerging market central banks, the recent turmoil in the market may provide good opportunities in EMD.

As Robin Creswell, CEO of Payden & Rygel's European operations points out: "Because lots of bonds have been heavily marked down, yields have gone up. Now you can buy bonds with yields where they were 18 months ago. Some clients are saying, ‘get me into EMD, or EMD and high yield'. There is a fundamental difference in structure of the high yield areas compared with 10 years ago. People are seeing the recent sell-off as a huge buying opportunity."

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