Question: “Which asset class returned 15.1% during the last year, 11.3% per year for each of the last two years, and 13.2% per year for the 11 years from March 1992 until March 2003?” (Merrill Lynch). Answer: Non-G7 sovereign debt.
Sound appealing? Possibly. Now if we said those returns were basic index returns, and that with the employment of a specialist manager those returns would have been significantly increased, would that sound more appealing? But how about if we came clean and said that by Non G7 sovereign debt, we actually mean emerging market debt? The chances are the appeal would wane.
Prejudices against emerging debt have ensured that the asset class remain a well-kept secret, but pension funds will have to admit sooner or later that their allocation to equities must be reduced, and in their search for alternative asset classes they may just stumble upon emerging debt, and realise that they have been missing out.
“Pension funds are going to be investors in this asset class sooner or later,” says Jerome Booth, head of research at Ashmore Investment Management in London. The attractiveness of emerging debt is obvious, he believes, pointing to the returns, negative correlation to fixed income and 0.3% correlation to equities, fundamental economic diversification, and half the level of volatility as the FTSE.
Booth is not simply selling his book either. Emerging debt really does appear to offer rewards. In terms of diversification emerging debt stands out. It offers negative correlation with fixed income, is counter cyclical to the business cycle, and were we to experience an oil-induced recession, emerging debt provides a cushion because one can invest in oil producing countries.
With regards to returns, the asset class speaks for itself. The spread over Treasuries is about 700bp, but Booth believes specialist managers can add huge alpha on a consistent basis. “If you employ a manager who knows what they are doing you can get much more than the index,” he says.
Volatility fears seem to be the key concern of investors, but just how volatile is emerging debt? “There is a big perceptual problem with emerging markets. If a country defaults it is regarded as a big event, yet defaults are an every day occurrence for single B, double B corporate credits – it just doesn’t make the papers. In the last 20 years I can count on one hand the number of major index countries that have actually defaulted,” he says.
Booth also believes countries to be rated more prudently than corporates, essentially leading to mispricing, and in turn “a free lunch”. When rating sovereigns, agencies have to take into account political risk and real unquantifiable risk that is difficult to understand, so for prudence sake agencies go for valuation of credit risk which will inevitably give the sovereign a lower rating.”
“Across a number of countries you therefore get a bias such that sovereigns will have a lower default rate than similarly rated corporates, and that is the inefficiency in the way ratings operate. Countries want to become investment grade but it takes then 10 to 15 years of paying on all their bonds to generate the reputation and creditworthiness to become investment grade, and whilst they’re doing that, the investor in those bonds is getting paid. And that is mispricing, and that is the advantage for pension funds with long-term horizons.”
Emerging debt is also a highly liquid market, accounting for 87% of the world’s population. Supply, therefore, is not an issue, with the size of the market driven by demand, and demand is increasing. Says Soren Bertelsen, chief portfolio manager for emerging markets at BankInvest, Copenhagen: “There are significant flows out of emerging market equities into emerging market debt.”
Consultants too will play a role in pushing demand for emerging debt, as they try to suggest alternatives to equities to their clients. Nick Horsfall, head of fixed income at consultants Watson Wyatt, is one such consultant that advocates an allocation to emerging market debt, believing that funds should reduce their allocation to equities and instead invest in other return-chasing assets, such as high yield, emerging debt, property and hedge funds.
Going forward though, returns are not expected to be as high, but emerging debt will still offer relative value in comparison to US treasuries, mortgages and investment grade corporate debt. Says William Ledward, portfolio manager at Fiduciary Trust: “The view through the rear-view mirror is superb. Emerging debt has outperformed every other fixed income class over the last five and 10 years, and has outperformed many of equity markets. But that is not the way you should invest – by looking backwards.” In the future Ledward expects returns to be nearer 10%, like those seen of the last three years, and with a specialist manager this figure could be higher.
Indeed, the advice for those considering the asset class, seems to be – go with a specialist. As says Bertelsen: “Avoid a manager that sticks too close to the benchmark, and monitor your investments regularly.”