Emerging market debt (EMD) is an asset class that that encompasses sovereigns and corporates, high yield and investment grade and dollar as well as local currency instruments.
Given this complexity, it is no wonder that market attention has only focused on the headline crises that have left deep-rooted prejudices within the minds of investors. Because of this, despite having had the largest return of any publicly available asset class since the early 1990s, it is only in the last couple of years that investor interest has taken off. Yet as Imran Hussain, head of BlackRock’s EMD team proclaims, “emerging markets represent one of the last great inefficiencies in the global capital markets that have yet to be fully arbitraged away”.
Given the breadth of investments now available under the category of emerging market debt, the question arises about whether the entire
universe of EMD investment opportunities should be regarded as a
single asset class. To the cognoscenti, certainly not, while those who have the view that Russia in 1998 is in any way comparable to Russia in 2005, with oil in 1998 at $11 a barrel and today at over $60, are probably better off staying away from emerging
What is clear is that the transition of emerging market debt from an alternative to a mainstream investment has already occurred for a large number of investors and it will be only a matter of time before the rest follow. As Kay Haigh, the managing director responsible for emerging market debt trading in emerging Europe, the Middle East and Africa at Deutsche Bank, argues: “The big thing which has happened to emerging markets is that they have become more mainstream, which means that more mainstream investors have started to take an interest in them with more commoditised products. Emerging markets have graduated.”
There are three key developments in EMD that support this view, which Jeff Kaufman from Putnam are:
q Firstly, better borrowers – “almost half of the EMD indices are now comprised of investment-grade countries that have sustained good policies (generally tighter fiscal and monetary policies in addition to more flexible exchange rates than in past decades). Furthermore, many borrowers are benefiting from a massively positive terms-of-trade shock in the form of high commodity prices and low interest rates”.
q Secondly, better investors – “Levered dealers and local banks have given way to more long-term investors that are not as susceptible to G3 volatility and margin calls. With 15 years of index data, large institutional investors feel they now understand the nature of EMD risks and are willing to build allocations steadily.”
q Thirdly, the fact that EMD has low correlations to the more traditional asset classes that have unappealing return prospects such as corporate equities and bonds from developed countries. “Current EMD yields are higher than for corporate bonds with the same credit quality, for no good reason.”
The EMD market covers sovereigns, quasi-sovereigns and corporate debt issued by over 30 countries. Instruments available include the remaining Brady bonds issued
after the Brady plan of the late
1980s and early 1990s, eurobonds, global bonds, tradable bank loans, local bonds and other securities, which now include a full range of derivatives.
Emerging markets do not behave as one asset class and investors are now realising that. As Haigh points out: “When the Asian and Russian crises occurred in the late 1990s there was a domino effect. Now, though, the correlation has broken down and people understand emerging markets much better than they had in the past. So when Argentina defaulted on their bonds there was no impact at all on Russia, unlike the situation six years earlier when Russia defaulted on its bonds.”
Jerome Booth of specialist EMD manager Ashmore Investment
Management adds that “people don’t realise it, but emerging debt is not high risk. There is a lot of prejudice. For the last five years local currency has been less volatile than US Treasury bonds and it is a great
Now that 40% of the major indices are investment grade, David Dowsett of Bluebay muses that “perhaps the investment grade section, and this is happening to some extent, will become part of the wider investment grade credit market, allowing the more sub-investment grade to become more of discrete asset class in hard currency terms. You may even see a purely sub investment grade index develop.”
The move by EMD towards becoming a mainstream investment class has been accompanied by the development of a much wider range of instruments. “When you look back at the 1997 crisis people were focusing on two types of products – foreign exchange and external debt (Brady bonds). Since then there has been a dramatic growth in derivatives.
“Now you have interest-rate derivatives and spread derivatives applied to emerging market debt, products like mortgage bonds, non-performing loans, credit/equity hybrids. Ten years ago emerging market players would spend 90% of their time looking at foreign exchange and bonds, now they only spend about a third of their time looking at them,” according to Deutsche Bank’s Haigh.
Bond indices are always somewhat of a double-edged sword and nowhere is this truer than in the case of emerging market debt. The philosophical dilemma is that in an equity index, a rising capitalisation of a stock occurs because investor perceptions of its prospects have increased, which justifies increased weightings. In a bond index, increasing capitalisation by one entity is predominantly through greater issuance of debt, usually associated with a weakening of credit worthiness.
Sticking closely to index weightings can and has been a recipe for disaster in the past, as in the case of the default of Argentina in 2001, when index-hugging managers found they were taking on more relative risk if they reduced their exposure to the country. As Ashmore’s Booth argues:
“The benchmark is much riskier than active management. When you get
an extreme event it is often signalled in advance; countries do not devalue or default before they have a serious problem and you can see that problem coming.
“Indeed, there are often several policy attempts to avert the problem before hand, so it’s not that hard to get out of things before they blow up. If you are passive then you are asking
The requirement for a benchmark for performance has, however, led to the creation of numerous EMD indices; the most broadly used being the JP Morgan’s Emerging Markets Bond Global (EMBIG) and the EMBIG Diversified. While some managers ignore the index altogether and others stick closely to it, many managers such as Pimco adopt another policy. They operate within a moderate band around index country weightings, but being prepared to zero weight credits with large downside risks irrespective of index weighting as in the case of Argentina in 2001 when it comprised 22% of the EMBI+ index. According to Pimco’s Lori Zarutsky: “We minimised the impact on our tracking error by over weighting other credits that, for technical reasons, had a high correlation with Argentina”.
The major development reflecting the increased interest in local currency bonds is the launch of a local markets bond index from JP Morgan. “Whereas most people have had local markets in their portfolio as a diversifier, now people will launch local market products as a distinct investment strategy,” says David Dowsett at Bluebay. “People who buy that may well be those who used to invest in Yen government bonds, or in the really old days, Italy and Spain. They may now choose an index which would allow them to invest in South Africa, Poland, Mexico all the way through to Brazil and Argentina in local currency.” Dowsett says this would give them an ability to “make a currency and rate decision as opposed to a credit decision. The asset class could morph off in those directions.”
“The bulk of issuance over the next five years is likely to be local currency government debt; it is going to be driven by the strong desire of developing countries to issue debt in local currency. That is going to be the big story of the next five years,” according to Ashmore’s Booth.
Local currency bonds are making rapid inroads into the thinking of bond managers, although Haigh at Deutsche Bank says that “local currency is the cutting edge of the emerging market space, not so much because of product complexity but rather complexity of the environment in which you invest – you have local regulations, etc. So if your pension fund manager has difficulty buying Russian ‘30s’ then they will definitely have incredible difficulty buying Ukrainian hryvna-denominated products”. She adds that “the local space is still more for the emerging market specialists”.
However, Payden & Rygel’s Kristin Ceva finds that “it has been getting a lot easier to access local markets, many of these countries are now on the Lehman global aggregate index. They have made great strides in terms of ease of access; they have worked hard at building out local yield curves. In Mexico, for example, there are plenty of bonds and it is very easy to get in and out. Some of the other countries where it used to be difficult for foreigners to access markets because of tax issues, you can now do it through total return swaps or credit-linked notes.
“If you don’t want to use those kinds of structures you could do NDFs non-deliverable_forwards, or deliverable forwards as long as the currency is convertible. So there are lots of different ways to access local markets,” she says.
The growth of local bond markets represents a positive step in the evolution of any country’s capital markets and generally can have positive benefits to the management of the domestic economies.
As Booth argues: “As an investor in emerging market local debt there are risks like local law and the possibility the value might be devalued away, but there is a positive side as well. The market is constantly pressuring the government to do the right thing, whereas with dollar debt the situation is much more binary and you come to a point where everything breaks down in one day.
“There is also an internal governance issue; local currency markets are increasingly dominated by domestic financial institutions and local accountability will be increased when you get to the stage where
debt is held by politically aware
local institutions rather than
From the investors’ viewpoint, according to Pimco’s Lori Zarutsky, investing in local currency takes advantage of: “an expected continuation in the improvement of the economic fundamentals of emerging market countries as a group; high real local interest rates and attractive interest rate differentials vis-à-vis US dollar interest rates; undervaluation of real effective exchange rates in emerging markets; natural protection from a possible secular decline in the value of the USD; and, finally, portfolio diversification via low correlations with other fixed income asset classes.”
However, Putnam’s Kaufman does inject a note of caution that many foreign investors are “willing to own local currency debt at remarkably low yields [JP Morgan’s new Global Bond Index, EM has a yield of_5.6%]. If new negative shocks were to hit EMD, under the new floating currency regimes, local currency investments would bear the brunt more immediately and significantly than external debt. Many new investors in EMD don’t seem to appreciate these new dynamics”.
The story of emerging market debt is essentially the story of a gradual rise in credit quality in a large number of emerging countries. This has coincided with, as BlackRock’s Hussain points out, a scenario where “long-only investors are being forced down the credit curve in search for yield and sovereign risk is a more sound concept in some respects, than corporate risk”.
Booth at Ashmore points out that “in emerging markets there has been a significant growth in reserves. In 2007 emerging markets will become net creditors, and virtually all the major countries have big fiscal surpluses. Turkey is vulnerable to being completely cut off from capital, as is the Philippines, but most countries aren’t. Russia has nearly $200bn (e163bn) in reserves, Mexico and Venezuela don’t need any capital, neither does Brazil. So macro concerns really come down to trying to look for opportunities to buy at cheaper levels rather losing your money”.
Investors are also making comparisons with corporate debt and as Haigh argues, “people are beginning to realise that there are much worse debt issues kicking around in investment grade”. Payden & Rygel’s Ceva echoes this view, saying: “We have been rotating out of high-yield and into emerging market debt”. Given a choice between GM and Brazil, many investors would prefer Brazil.
The market as a whole has also made the differentiation between credit quality of corporates and that of EMD. Booth recalls: “On the day GM issued their profit warning treasuries rallied, with a flight to quality, and emerging market debt rallied with them. That is very telling. It says the market has differentiated between emerging market and high-yield debt.”
Views on individual credits will of course vary between managers. Booth sees that “there are a couple of countries - Argentina and Ecuador - that have strong incentives to default again. They are congenital defaulters, but the majority of countries are not that vulnerable. Russian debt to GDP is about 10% now and it is entering single figures.” But for Dowsett at Bluebay, “Argentina is a very positive story. We like a lot of the local debt opportunities. We still like the Brazil, which is generating trade surpluses of $5bn a month. We still like opportunities in the Philippines and Ukraine at the sovereign level.”
For fund managers, emerging market debt is certainly one of the more interesting asset classes. As one manager enthused: “The market is inefficient. It is about getting inside
the head of a finance minister, working out what he is trying to do, telling him he is wrong, having him fired maybe.”
Managers will always seek to differentiate themselves through developing what they perceive to be a superior strategy, but it is fair to say that most emerging market specialists tend to do well when emerging markets do well and relatively badly when they don’t.
As spreads have come in, the potential for the double-digit returns seen in the past has diminished except, perhaps, through the more illiquid esoteric areas such as distressed debt. This is an area only a few specialists, such as Ashmore, are able to exploit effectively and requires very different skills a it is more akin to private equity than debt management. “With distressed companies we look at something that is good at the operational level but at the holding company level it has way too much debt and so needs some sort of restructuring. We have to understand the bargaining power of the various portions in the capital structure, and then, very early on, we have to have a plan of exit.”
The main message, according to Deutsche Bank’s Haigh, is that “emerging markets have become much more mainstream, much more user friendly. There are more products and there are many more mainstream people investing in them. They view emerging markets as an elegant way of increasing their portfolio returns, firstly because there are still higher returns to be had in emerging markets and secondly, because as an addition to one’s portfolio, emerging markets have the key attribute of not being very correlated with other asset classes.”