Emerging Market Debt: Missing linkers

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Emerging-market inflation-linked bonds are entering a new era. Martin Steward asks how they might fit into European institutional investors’ portfolios

As an asset class, you know you’ve arrived when you get your own exchange-traded
 fund. For emerging market inflation-linked bonds the happy day came with the arrival of a SPDR product in April this year.

The time feels right. The recent addition of India after a 15-year hiatus, and plans announced by Nigeria, Indonesia and the Philippines, will swell a universe that already includes bonds from Brazil, Mexico, Turkey, Israel, South Africa, Poland, Uruguay, Thailand, Chile, South Korea, Romania, Malaysia, China, Peru, Russia and Hungary.

Eleven of these issuers make it into the leading benchmark, the Barclays Emerging Markets Government Inflation-Linked Bond index (EMGILB); and the nine that make it into the Barclays Emerging Markets Tradable Government Inflation-Linked Bond index (EMTIL), which limits single-country allocations to 25% and which the ETF tracks, are Brazil, Mexico, Chile, South Africa, Poland, Turkey, Israel, Korea and Thailand.

Estimates of the size of the market vary greatly, generally topping out at $500bn. Brazil alone accounts for about 60% of emerging market issuance; and behind Mexico and Israel there is a long tail of issuers included in the count by some but not by others, for various reasons, such as: because they never trade; because of capital controls; because no-one trusts their inflation statistics. Most would agree that Colombia and Peru, say, are illiquid.
But some would put Chile into the liquid camp – after all, it is a big issuer and its linkers are included in some nominal emerging-market bond indices – while others call it illiquid because it’s so tough to get an offer when the local pension funds gobble up new issues so greedily. For many, EM linkers do not feel like a proper asset class because it is a bit of a dichotomy of whales and tiddlers.

“We have considered index-linked bonds in the past as an alternative to conventional bonds,” says Geik Drever, director of pensions at the West Midlands Pension fund, which she describes as “a committed investor” in emerging market debt. “However, due to the market’s immaturity and niche status we decided to hold off until the investable universe was larger and more countries were issuing such bonds. We continue to monitor the situation and will review again at the appropriate time.”

But the direction of travel is encouraging, as the ETF suggests and the entry of countries like India promises.

“It has currency controls at the moment so we don’t really look at it, but eventually India should be a big issuer, given the size of the economy,” says Andy Weir, manager of the Fidelity Global Inflation Linked Bond Income fund. “That will help address some of the market-cap concentration in Latin America.”

That is an enticing prospect for investors who have spent 10 years watching emerging-market inflation-linked bonds outperform even emerging-market equities. Since Turkey first issued in 2007, its bonds peaked at real yields of 11% the following year and then rushed down to real yields of less than 1.5% in 2013. Brazil’s real yields have tumbled a similar distance – and yet still offer 3-4%, arguably with a credible inflation threat in the background. While it feels inevitable that the big gains from falling real yields are behind most markets, in relative terms investors can still pick up almost 300 basis points of extra real yield by moving from a global to an emerging-market inflation-linked universe.

For investors with inflation-sensitive liabilities – or even those concerned about inflation uncertainty – the idea that one might be able to buy protection against this global phenomenon without having to put up with negative real yields from developed markets is compelling.

“If developed markets start to feel an uptick in inflation, that will be felt by emerging markets – but to a greater degree,” says Nick Shearn of Bluebay Asset Management’s Emerging Market Inflation-Linked Bond fund. “It makes perfect sense for European investors to start thinking about emerging markets for protection of part of their portfolios, and we believe this asset class has a permanent place within any investor’s long-term strategic asset allocation if that investor has inflation exposure that needs to be hedged.”

European institutional investors with inflation exposure – like Dutch pension funds, for example – are not yet persuaded. ABP, in its annual report for 2011, noted that the emerging market inflation-linked bonds that were placed into its ‘alternative inflation’ portfolio underperformed so badly, thanks to exchange rates, that the mandates in this portfolio were terminated.

“There is basis risk between the assets that are sensitive to European inflation and the inflation that affects our liabilities, of course, but going into emerging market inflation-linked bonds would make that basis risk much larger,” says Axel Röhm, in charge of emerging market debt at PGGM. “For that reason, we maintain it as part of our risk-seeking exposure within emerging market debt. There are discussions as to whether a global inflation-linked mandate might also be a hedging possibility, but one has to recognise that the premium from emerging market inflation-linked may not be for the global inflation risk you take but more for the idiosyncratic and illiquidity risks.”

Röhm has a point. Buy US TIPS or UK linkers and the inflation you buy will be 90% correlated with European inflation. Buy the emerging market universe and that can drop to as low as 30%. EM linkers are more closely correlated with EM nominal bonds, and even world equities, than with UK linkers. Greater exposure to food and energy makes emerging-market inflation a fairly good hedge against the global drivers of European inflation, but not much use against the more dominant local drivers.

“EM linkers should be considered in the framework of a global portfolio,” argues Enzo Puntillo, head of fixed income and manager of the JB EM Inflation Linked Bond fund at Swiss & Global Asset Management. But while the idea of global inflation protection is one of the reasons he gives, “the primary argument for EM linkers in a pension fund portfolio is not the inflation protection, but the high real yield”.

But is a 300 basis point average yield pick-up really that high, when we understand that there are clear technical reasons for the extremely low real yields in developed markets? And is the nature of emerging market inflation-linked issuance changing to the extent that capital depreciation has become a much bigger risk?

When Israel became the first emerging country to issue linkers in 1955, it was off the back of an inflation crisis caused by shortages in foreign currency and consumer goods. That set the pattern: Latin America came to market with linkers in the 1960s because investors were too frightened by inflation uncertainty to buy nominals, and another wave of issuance met the hyperinflation episodes of the 1990s. Until very recently, this inflation history largely determined who issued and the high premiums on offer.

“The common theme is when inflation locally has been extremely high – greater than 30% – and no one wants to buy nominal bonds,” as Ram Bala Chandran, senior portfolio manager on Neuberger Berman’s local-currency emerging market debt fund, puts it.
But issuing linkers does, of course, provide an incentive to control inflation – especially when combined with a bigger, politically-engaged middle class. Brazil, Turkey, Mexico, Israel, South Africa have all got on top of their inflation, but continue to issue linkers even as they issue local and hard currency nominal bonds.

“That is evidence of a desire to issue as well as, or instead of, a necessity,” suggests Jim Hurlin, investment specialist at Capital Group.

“A lot of political pressure builds if inflation starts to wipe out citizens’ wealth,” says Jan Dehn, co-head of research at Ashmore Investment Management. “Look at Mubarak and wheat prices, or Brazil and its bus fares. As soon as inflation hit 6.5%, what has Brazil had to do? Completely dismantle capital controls, allow its currency to appreciate and raise rates – all in the middle of a slowdown in growth.”

At Ashmore, the view is that the new reality is one of strengthening currencies, slowing exports, importing deflation, and the odd intervention to lower the exchange rate limited by domestic political pressure not to allow inflation to return.

“One of the most widespread misapprehensions about emerging markets is that, at any point in time, they are about to explode into hyperinflation,” says Dehn. “But I think these are the countries that believe they are going to manage their inflation rates pretty well and think that the market hasn’t caught up with that fact.”

Even if you don’t buy into that entirely, today’s issues do not necessarily represent free money from borrowers under pressure.

“Some recent issuers are simply addressing local needs,” says Jonathan Baltora, manager of AXA Investment Managers’ Universal Inflation Bonds fund. “What we see in Thailand or South Korea, for example, are issues for the nascent local pension funds – that’s why Thailand has been issuing long maturities rather than short.”

That ready demand takes still more pressure off governments to offer stratospheric real yields. It is important not to overstate this – high levels of inflation combined with relatively high real yields can still be found in Brazil, Turkey, Uruguay and elsewhere, and portfolio managers who might expect linkers to price 30 basis points above the breakeven rate in the US market would still want that to be more like 100 basis points, on average, for emerging markets. But the significant point is that they now know what the breakeven rates are in these markets: the choice between nominal and linker is now available, so simple views on emerging-versus-developed inflation can be supplanted by more interesting views on inflation (or central bank policy) country by country, within emerging markets.

“A lot of nominal-bond funds will now have off-index positions in linkers as a play on their view of inflation – and that’s very different from the old style,” notes Weir at Fidelity. “Over time these markets will trade much more like developed markets.”

As such, probably the most efficacious use of this growing EM-linker toolkit has less to do with getting global inflation exposure and more to do with managing the risk in emerging-market portfolios.

At first glance it is not clear what benefit the linkers bring, now that most emerging-market bond issuance is in local currencies. The reason most European investors hold these bonds is essentially for the carry – structurally higher inflation means structurally higher interest rates – and for the long-term convergence of real exchange rates with those of the developed world. These are both plays on inflation – so if local-currency bonds provide it, why the need for linkers? There are two reasons: first, exposure to inflation through local-currency bonds necessarily comes through movements in the nominal exchange rate, largely determined by central bank action. The less ‘orthodox’ the central bank, the weaker the exposure to changes in the real exchange rate.

“If you want to participate in the real appreciation of EM currencies then inflation-linked bonds will capture it, whether it comes through the nominal exchange rate or through domestic inflation,” as Hurlin puts it.

Second, and perhaps more pertinent, local-currency nominal bonds offer little protection against unexpected inflation that is short-lived or catches central banks behind the curve.
The nominal cash flows get de-rated against inflation and currency weakness is both a symptom of domestic inflation and the channel through which further external inflation is imported. While the duration and currency exposure in inflation-linked bonds gets hurt, too, the indexation can offer a powerful counterbalance – which portfolio managers can maintain while shortening duration.

“What they protect you against are unexpected but contained inflation surprises – a temporary commodity or exchange-rate movement turning up in the CPI numbers, for example, or a modest policy mistake,” says Dehn. “These episodes are very specific and at other times you are better off in the nominal bonds – if only because they tend to offer more liquidity. That’s why inflation-linked bonds should be held as part of a diversified portfolio of emerging debt.”

Large European institutions that hold these bonds agree, for the moment. Röhm at PGGM says it is “far too early” to consider this a separate asset class for strategic asset allocation and, as we have seen, he is deeply sceptical of its role as any kind of liability hedge.

“But there is not a black-and-white distinction between the liability-hedging and return-seeking portfolios,” he adds. “We prefer to have return-seeking assets that are not negatively correlated wth inflation – because most risky assets are correlated negatively with shorter-term inflation-shocks – and this is where we see a place for emerging-market inflation-linked bonds.”

So, while this fast-growing bond market is certainly a valuable missing link in emerging maket portfolios, it is not the missing link in global inflation portfolios – at least, not yet.

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