Emerging markets came out of the crash relatively unscathed, in contrast to the still struggling developed economies. Moreover, the dire straits the PIGS (Portugal, Ireland, Greece and Spain) find themselves in has drawn attention to the whole issue of sovereign risk within developed markets, and the perception that EMD is a higher risk asset class compared to developed market sovereign bonds.
The debt of emerging markets has evolved towards becoming essentially an investment grade asset class, whilst the debt of some of the sub-merging markets in developed Europe has become junk. It is seen as quite acceptable that corporate credits may have higher ratings than the sovereign risk of their own jurisdiction. Investors and consultants who have not yet grasped the depth of the changes will find themselves struggling to determine what should be their strategy towards investing in emerging market debt.
Perhaps the most significant question to ask about emerging market debt is whether it should still be regarded as a single separate asset class at all. As Peter Marber, head of HSBC/Halbis’s EMD team says: “People used to ask what is an emerging market and the answer would be, I can’t describe it but I’ll know it when I see it!” But as he argues, whilst EMD used to be an accurate description of a well-defined and narrow investment opportunity, this is certainly not the case any longer: Spreads on developed countries such as Greece are far higher than most emerging countries and the total size of the EMD market is 20% of the global bond markets.
What used to be exclusively a hard currency market is now dominated by local currency bond markets with a market capitalisation of $6.8trillion verse $1.4trillion for hard currency bonds (as of 31st December 2009 according to HSBC/Halbis). Institutional investors are shifting to local currency EMD not only because of the yields available and the size of the markets, but more importantly, because of the view that emerging market currencies are likely to appreciate over the longer term. Beyond sovereign debt, emerging market corporate debt issuance is increasing as companies in the developed world expand to the size that debt issuance in hard and local currency becomes feasible, with hard currency corporate debt issuance now exceeding that of sovereigns. Credit ratings for such debt varies widely from AA for some issuers in Asia to CCC for issuers in Argentina and Venezuela.
Technically, emerging markets are defined on the basis of GDP per capita and on that basis, the poorly performing economies of the PIIGS countries would be still regarded as developed by any standards. Greece is not going to join the major EMD indices no matter what happens to its bonds. Despite this distinction, managers such as Marber would argue that EMD today is an integral component of the global debt markets. But the profound changes in the EMD markets have not yet been reflected in the global aggregate bond indices and perhaps as a result, investors are still generally underweight.
However, there certainly appears to be a trend of diversifying bond exposure away from the developed markets given events of the past few years. Institutional investors need to address the question that Michael Hasenstab, co-director of Franklin Templeton’s EMD group asks: “Are US treasuries really the risk free asset they have been seen as in the past, given the developments in the marketplace, with the US deficits essentially being financed by printing money?” Whilst the developed markets has debt-to-GDP going to 100%, in emerging markets, the figure falls to below 40%: “If you are thinking about concerns about fiscal indebtedness, the ability to repay your debt, it’s actually the emerging markets that are in the better position,” points out Hasenstab.
With the EMD marketplace split between hard currency sovereign, local currency sovereign and essentially hard currency corporate debt, institutional investors also have to decide whether they should allow a manager to switch between these sub-categories, or explicitly award mandates for one or more of them. The marketplace may even be evolving to the position where hard currency sovereign debt is just seen as one element of global hard currency debt markets, whilst local currency debt is the real opportunity for generating higher returns through both higher bond yields and currency appreciation. Hard currency debt means essentially taking views on spreads above US treasuries whilst for international investors, local currency debt means taking views on both local interest rates and also on currencies, and these can be tackled independently. Fund managers need to have processes that tackle both in a systematic manner.
EMD is an asset class that any broad-ranging fixed income manager now has to have expertise in. This is clearly seen in the number of new EMD strategies that are being offered in the marketplace. The flows into the EMD markets by institutional investors shifting assets from developed markets is a trend that is unlikely to be reversed over the long term. But the perceptions and prejudices that sometimes guide investor movements short term as we have seen in recent years, means that EMD for better or worse, will be subject to short term volatility arising from contagion from the developed markets. Moreover, the structure of indices and the management of EMD portfolios is often based on historical perceptions of emerging markets that are no longer valid. In particular, with credit ratings of countries such as Greece now far below that of many investment grade emerging markets, it is clear that the framework for incorporating opportunities within EMD needs to be radically changed for many investors. EMD is not one asset class and whilst emerging countries themselves can be easily distinguished from developed on the basis of per capita GDP, this should not be the basis on which investors should analyse their debt.