At the end of 2003, the market for emerging debt had posted the strongest performance compared to any other bond class over the past 12 years. On average, the out-performance was some 300 basis points per annum over that period. This high yield class of assets will always tempt investors in search of performance. This is despite the crises which have affected the market: Mexican peso in 1994, Asian crisis in 1997, Russian crisis in 1998, devaluation in Brazil in 1999, Argentine default in 2001, and the recent crisis in Brazil in 2002 prior to the election of the current President Lula. Experience shows us, paradoxically, that these are extremely opportune times in which to invest in the emerging markets. The contagion still unfairly affects all securities without distinction and the distortions caused still offer opportunities for arbitrage on different securities affected for technical market reasons (flows, repurchases, liquidity, voluntary exchange and so on).
The emerging debt market
If one retains solely sovereign and quasi-sovereign debts denominated in US dollars and euro, these amount to approximately 450 billion USD. If one adds to this all the local markets, then the result is 1,400 billion USD. From a regional point of view, it should be stressed that 50% of that sum is in Latin America, 25% in Europe and 15% in Asia, the rest being divided between Africa and the Middle East. In 10 years, the number of countries included in this investment universe, some 30, has multiplied threefold; 19 new countries fulfil the criteria of liquidity per instrument and have been authorised to appear in the EMBI+ Index.
The structure of instruments has also simplified: restructured bonds give way to “plain vanilla” bonds, preferred much more by investors since they are easier to trade. At the same time as the increase in the different types of instruments exchanged, the use of derivatives such as options, CDS (Credit Default Swaps) and forward structures have contributed to improved liquidity.
The distribution per rating is as follows: 27% BBB, 23% BB, 29% B, 7% CCC or NR. The default rate on sovereign debt is lower than that on corporate securities: 9.3% against 11.8% over 10 years (source: Moody’s Investor Service). Over the last 10 years, the quality of credit has improved greatly: from 1993 to 2003, the part of below or equal to CCC grades went from 25% to 7%. This is a consequence of considerable improvements at the economic level and also great progress at a structural level.
This trend is set to continue, or even to accelerate, bringing about improvements in the ratings given by specialist agencies. For example, within the context of their integration, new European Union member states have made significant efforts as regards reorganising public finances and implementing structural reforms.
An asset class for
The correlation of the High grade and High Yield credit markets with Emerging markets is low and often negative at times of crisis with government bonds.
Correlations between the different emerging countries have also been down over recent years. Leverage has been reduced. Following the different crises, investors are now much more selective than previously. Country analyses are more refined in view of the greater regularity of official publications and greater transparency (e.g. exchange reserves are published daily in Brazil, and each week in Russia and Mexico). (See table 1).
Structural improvements were made
Prospects are extremely favourable, after an exceptional year in 2003 at a financial level for all the emerging countries:
q Since 1996, 19 countries have abandoned fixed exchange regimes in favour of floating regimes;
q The amount of exchange reserves has been increasing constantly for five years, thus reducing the risks of non-payment and inflation has fallen substantially in 10 years;
q The states are undertaking structural reforms recommended by the IMF: privatisation, social security reforms, pensions, institutions and so on and this independently of the parties in power (e.g. Brazil, Mexico, Russia).
Less dependent upon external capital flows than they were in 2002, these countries appear also to be less exposed to a liquidity crisis and to turbulence on the international financial markets:
q The improvement of foreign trade accounts came about by virtue of the good momentum of exports, (acceleration of world demand, effect of commodity prices) associated with imports slowing as a result of the weakness of domestic demand;
q Although levels of public debt are still very high over the entirety of Latin America (often close to or more than 60% of GDP), the profile has generally improved.
On a structural level, the emerging countries have always drawn considerable benefit from extricating themselves from crisis. This is explained principally by the fact that international aid packages provided by the IMF are accompanied as a counterpart by major requirements in terms of measures to be taken and structural reforms to be implemented. In the case of non-fulfilment, the sanctions applied by the markets are rapid and severe, and the correction can be violent. Respect for reform agendas is essential: in this regard, social security reform in Brazil provides a very encouraging sign and should contribute to the resolution of the currently high level of public deficit not being dependent upon growth.
A key factor is that the risk of contagion of these crises is continuously diminishing. The broadening of the investor base is contributing to the dilution of contagious risks (local pension funds, mutual funds, long-term investors). The contribution of new information technologies and the sophistication of participants in this market have in fact contributed to a better analysis.
Indeed, the Argentine crisis at the end of 2001 did not spread to its neighbours. Similarly, the banking crisis which affected Russia in July 2004 did not evolve into a systemic financial crisis: globally the markets identified the risks perfectly well, the beginnings of the liquidity crisis not having contagious effects on Russian risk and a fortiori on all the emerging countries. More recently still, the political crisis in Venezuela was confined solely to domestic affairs.
The sharp fall of risk premiums should not obscure the risks which remain.
Despite the good performances achieved by this class of assets, 14% in 2002, 28% in 2003, and a strong improvement in margins from 700 basis points at the beginning of 2003 to 380 points (higher) in January 2004, risks remain.
For instance, Brazil finances a major proportion of its short-term public debt going as far as indexing it to the exchange rate, which makes it particularly fragile in the case of shock. That is also the case in Turkey, which is extremely sensitive to the level of its domestic rates. Russia is still extremely dependent upon the level of the price of energy and the Yukos case reminds us that corporate law in Russia needs substantial reforms.
As a whole, Latin America (and in particular Brazil) remains vulnerable to an increase in risk aversion, since advantage was not sufficiently taken of the exceptionally favourable context in 2003 to reduce public debt to a significant extent and to increase the structurally low rate of savings.
Last year, these economies benefited from various factors (decrease in risk aversion, abundant liquidity, depreciation of the dollar and the increase in the price of commodities) which simultaneously brought about a sharp fall in risk premiums as well as an extremely favourable evolution of the stock markets and a sharp appreciation of exchange rates.
Finally, there is a risk that the current environment of rising rates in the United States will have an impact on a number of emerging countries in severe need of financing, such as the Philippines, Turkey and again Brazil. The attractiveness of the emerging markets could ease somewhat and be accompanied by a hardening of financing conditions for those countries.
Favour a “long/short” approach to a
“long only” approach
It is against this background that we consider it opportune to adopt a long/short approach, with strategies anticipating possible corrections of a market, which has become expensive in certain regards.
In contrast to a “long” only fund, a fund combining the taking of short (sell) positions and long (buy) positions is the best means of optimising market exposure in case of shock or crisis on the one hand, and benefiting fully from recovery from crises on the other hand. A Long Short fund of sovereign or quasi-sovereign debt from emerging countries is favourably suited to a diversified global credit allocation.
With its considerable experience of the emerging markets, the management team for the Emerging Markets strategy at Dexia Asset Management benefits from the research work carried out by four recognised economists and also profits from synergies with internal quantitative research. Being a matter of sovereign and quasi-sovereign debt, the investment universe of the fund Dexia Long Short Emerging Markets offers significant liquidity, enabling the consequences of a crisis on the investment portfolio to be strictly limited. The repo market has developed sufficiently to offer the manager plenty of room for manoeuvre and good liquidity.
Only slightly correlated to the traditional asset classes, alternative management enables market inefficiencies to be exploited and offers a broad diversification of the management techniques used. Dexia Asset Management has been a major actor in this field for almost 10 years, and more particularly since 1996 with the launch of one of the very first convertible bonds arbitrage funds in Europe. At present, Dexia Asset Management covers the majority of alternative management strategies, with considerable capacity to innovate and beneficial synergies between the different processes.
A team of more than 50 people, internal research and collaboration with the university world enable Dexia Asset Management to play a principal role as regards product innovation. The launch of new processes, on average one every 18 months, is one of its skills, and at the same time a strategic choice, by virtue of which Dexia Asset Management can position itself against the competition. Finally, the quality of its know-how is reflected in the figures, since Dexia Asset Management appears among European leaders in Alternative Management, with more than 4.5(3)
billion euros under management.
(3) As at 30.06.2004
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