Time to look again
Many institutional investors have negative feelings about emerging market debt. It has certainly trod a rocky path since it was reborn courtesy of the Brady plan at the end of the 1980s. First, there was the collapse of the Mexican peso in 1994–95; then there was the Asian crisis in 1997; Russia’s default on its domestic debt and some of its external debt followed in the second half of 1998; even last year, one of recovery, Ecuador defaulted on its external debt. More recently, Ukraine has presented a restructuring offer to holders of its external bonds.
Despite these momentous events, emerging market debt has given a good return to those European investors who were in at the start (December 1990). The table shows the total return and volatility on three asset classes, two of which perhaps dominate European pension fund portfolios, domestic government bonds and equities. For the sake of simplicity, German bonds and equities are used as a proxy for European bonds and equities. The third asset is the JP Morgan Emerging Market Bond Index (EMBI), an index of dollar-denominated Brady bonds, hedged into the Deutschemark and, after 1999, its successor the euro.
Emerging market debt hedged back into the Deutschmark gave an annual return of almost 17% between 1991 and 1999, almost eight percentage points ahead of German government bonds and only one and a half percentage points behind German equities.
It has to be admitted that emerging market debt is also a volatile asset class. The annualised standard deviation of monthly returns was slightly higher than the annualised return, a less favourable risk/return trade-off than German government bonds and about the same as German equities.
This only goes to show that emerging market debt behaves more like equity than bonds. US Treasury Secretary Larry Summers’ description of corporate high-yield debt as ‘equity in drag’ applies even more closely to emerging market debt! In any case, it is questionable whether the standard deviation of monthly returns is the best measure of risk for a long-term institution such as a pension fund.
It is a commonplace of modern portfolio theory that even if one asset is more volatile than another, the most risk-averse investor should still hold some of the risky asset if its returns are not correlated with the less risky asset. That applies to a small extent to emerging market debt. A portfolio composed of 98% German government debt and 1% emerging market would have given a return 15 basis points in excess of that on German governments at the same time as reducing risk by one basis point. Even the most conservative German pension fund should have had a small allocation to emerging market debt in the 1990s!
Figure 1 shows the efficient frontier for these three assets during the nine years from December 1990 to December 1999.
A feature of European pension funds’ asset allocation in the 1990s has been a shift out of government bonds into equities, as yields on government bonds have fallen and investors have turned to equities to achieve target rates of return in excess of that likely from bonds. However, the composition of the efficient frontier suggests that the investor who was prepared to incorporate extra risk in his portfolio should initially have substituted emerging debt for domestic government bonds and only later added equities on a substantial scale.
For example, at an annualised risk of 6%, the optimal portfolio would have been composed of 66% government bonds, 27% emerging market debt and only 7% equities. It is only at greater levels of risk that equities begin to contribute a significant share of the optimal portfolio, as Figure 2 shows.
Of course, the past is not a good guide to the future and it is unlikely that emerging market debt will perform as well in the next decade as it has in the past nine years. However, the same point applies even more strongly to equities, and even to some extent to government bonds. The forward-looking price-earnings ratio on almost all European stock exchanges is well over 20, a high level by historical standards, while it is difficult to see European government bonds returning 8% in the next decade when the 10-year yield is around 5%. The average yield on dollar-denominated emerging market debt is 13.4%, about 670 basis points above US Treasuries. At a p/e ratio of 22, are European equities really going to return 13.4% a year in the next decade?
The time has come for all European pension funds to consider adding some emerging market debt to their portfolio.
William Ledward is head of emerging market debt research at Fiduciary Trust in London