The improving image of EMD

The increasing importance of emerging market debt as an asset class reflects the seismic shift we are witnessing as power and relative wealth moves from the developed markets to the developing, argues Joseph Mariathasan

Just a few years ago, emerging market debt (EMD) meant hard currency sovereign debt. Today it has split into three main subclasses - hard currency sovereign debt, local currency sovereign debt and hard currency corporate debt. There is also a future category of local currency corporate debt that is still too small and illiquid a market for most investors, but that at some stage might also become a mainstream component of a fixed income portfolio.

In addition, the index-linked market has developed to encompass a broad range of countries while the development of derivatives is following the path of the developed bond markets, albeit with very varied progress among different countries. In the meantime, there is still some way to go for the acceptance of EMD within institutional portfolios as investors grapple with the complexities of a changing world, where the credit rating of Botswana can match that of Italy, and treating the US Treasury market as the ultimate risk-free asset class may no longer make sense.

Increased allocations to EMD are as much the result of changes in perceptions by investors towards emerging markets generally as to changes in the reality of the macroeconomic environment that are driving credit ratings of emerging countries upwards.

There have been six waves of global investing in the modern era, according to Peter Marber, (pictured right) head of global emerging markets fixed income and currencies at HSBC Halbis. The first phase was in the early 1980s when pension funds started to diversify away from their domestic markets.

The second was when multinational companies such as Shell took stakes in overseas companies in the same industry in the late 1980s, and the third phase was in the early 1990s when there was G10 investor interest in emerging stock markets, with the first emerging markets equity index produced by the IFC in 1993.

The fourth phase was in the mid-1990s when there was a big expansion in the number of emerging countries suitable for investment, including not only Mexico and Singapore, but also Russia and post-Tiananmen Square China. The disintegration of the Soviet Union produced 12 new countries with 12 yield curves, stock markets and currencies, expanding the emerging market universe further.

The fifth phase was when the late stage emerging markets such as Korea and Chile, which were themselves investment grade, started asking the question why they themselves were not invested in emerging markets and began the process. The sixth phase is what we are seeing now, with emerging market countries, in something of a complete role reversal, taking major stakes in struggling G10 companies such as Citigroup. Examples include Tata buying Rover and Mittal buying Arcelor. Many recent strategic investments by sovereign wealth funds into major financial US and European institutions are just another manifestation of this.

The result of these developments has been an increasingly positive set of perceptions of emerging market investment alongside the increasing credit quality, with the major index now over 50% investment grade compared with 10% just seven years ago.

The real wake-up call for EMD investors came in 2005, according to Margaret Frost, global head of bonds at consultancy Watson Wyatt. She says: “Until then, high yield debt and EMD were mentioned in the same breath. Then General Motors and Ford got downgraded to junk bond status, flooding the high yield market with their debt. However, there was no contagion in the EMD marketplace, which outperformed. EMD has also held up much better than EM equities and US credit.”

While September saw violent fluctuations in the wake of the collapse of Lehman Brothers, in the year to July 2008, HSBC Halbis’s figures on debt returns, according to Marber, show that US high yield gave a negative return of 2.1%, while EM hard currency returned 5.1% and local currency returned 13.7%, comfortably beating the return on US Treasuries at 10.3% despite the flight to safety of investors fleeing from the collapsing asset backed debt market.

Allocation to EMD

An increasingly important question will be the appropriate allocation to EMD and in which subset of the marketplace that should be. “When compared with any US credit product, emerging debt has performed far better,” says Marber. “In fact, even with the major defaults in EMD such as Argentina and Russia, the returns for EMD as a whole have beaten every other debt asset class for the last 15 years.”

Jerome Booth, head of research at the London-based emerging market specialist Ashmore, makes the point: “For the best part of 10 years, emerging market currencies have been kept artificially low and now everything is happening to change that. The big structural problem in the world is the US current account deficit of $750bn (€550bn) a year. Will the rest of the world finance this? The answer is no, apart from central banks. So there is a need to devalue the dollar much more.”

In such a scenario, emerging market currencies would, over the longer term at least, continue the appreciation they have been seeing, although the recent dollar appreciation indicates that this is not always a one way bet.

Many managers running global aggregate investment grade portfolios will already be incorporating an element of emerging market debt within it.

PIMCO’s Gayle Tzemach explains: “Where consistent with client guidelines, we are seeking tactical exposures on an opportunistic basis. Specifically, we are incorporating positions in EM currencies and local interest rates in countries exhibiting strong macroeconomic fundamentals, robust fiscal policy discipline and long term growth.”

Marber goes further: “We recommend hard and local currency EMD as credible substitutes for a global bond mandate with better return potential than standard dollar, yen and euro bond allocations.”

But actual allocations by institutional investors are typically less than 5%, despite being 13-15% of the global debt markets according to Marber, which he sees as “woefully inadequate”.

But for Frost, EMD is a return seeking strategy that does not match liabilities. While sovereign wealth funds are more prone to make allocations to EMD, for pension funds, it is one of many return-seeking assets, so the allocation should be fairly small, she argues. Her colleague, Mark Horne, a specialist on EMD managers, adds that while the allocation that is recommended will vary depending on the governance levels of the pension fund they are advising, the maximum allocations are unlikely to be more than just a few percent.

Macroeconomic scenario

Michael Gomez at PIMCO makes the point in a recent note that in the last few years, the US monetary policy has been the anchor for the monetary policies of many emerging countries. With the anchor gone as the US Federal Reserve focuses on preventing a 1930s-style downward spiral, many emerging market countries find themselves anchor-less and facing a difficult choice between inflation and growth. There are pronounced regional variations in the actions of central banks. “Latin American central banks are acting very strongly to control inflationary trends and are not afraid of pushing up interest rates to clamp down on inflation,” says Horne. “In contrast, there is a widely held view that some of the Asian countries are more susceptible.”

Cristina Panait, fund manager at Payden & Rygel, says Latin American countries such as Mexico and Brazil have raised interest rates while Asian countries such as Indonesia and the Philippines have been more complacent, allowing appreciating currencies to take the strain in combating inflation.

Russia had also been in this category.But as Yerlan Sysdykov, (pictured left) an EMD fund manager at Pioneer Investments, argues, an appreciating currency is a very poor instrument to control inflation as a lot of it is structural in nature. “The Russian government has not been very successful in controlling inflation,” he says. “They tried to set price freezes but this does not work in the long term and just leads to the disappearance of products from the marketplace.” As a result, interest rates have now been raised aggressively to eradicate any lingering tendency towards hyperinflation, a fear that still haunts the emerging markets.

Other emerging European markets, such as Poland and Hungary, are converging towards the euro markets leading, as Tzemach points out, to an analogous situation with Italy and Spain during the 1990s, when their government bond spreads tightened in anticipation of euro adoption.

Sovereign bonds

The local currency debt market, at $2.5trn, is now five times that of dollar debt according to Panait. “There has been less and less issuance of external debt so local markets have become more attractive due to tight valuations and restricted supply of dollar-denominated debt.” Sovereigns have taken steps to buy back a lot of debt and their financing needs are not very large so the external issuance is around $30-40bn a year.

As a result, managers such as Western Asset Management’s senior product specialist Michael Story see little value in hard currency EMD. “There has been an amazing movement of sovereign spreads from a peak of 1,500 bps to 300 bps but now the returns from sovereigns are limited and may be closer to 7-8% in the future rather than the 11-12% seen in the index over the past five years,” he says. Not surprisingly, fund managers and investors are focusing increasingly on the local currency market, with The Hague-based Mn Services EMD fund manager Salman Saif happy to have equal weightings of both if he faced no investment restrictions. But in the longer term, it is clear that the local currency market will offer value: “We don’t see this as a cyclical phenomenon but a secular trend of some rising emerging market currencies,” declares Story.

Not surprisingly, there is a substantial increase in fund management resources being devoted to local currency debt. For example, emerging market equity specialist Rexiter Capital Management, a member of the State Street Global Alliance of smaller, specialist investment management companies, took on a debt team and launched a local currency EMD fund a year ago for US investors.

John Morton, fixed income CIO, now sees the timing as attractive to launch a European product. “We have seen a large degree of interest from the Netherlands, the Nordic countries, Switzerland, Germany and Italy,” he says. However, while the long-term prospects may seem attractive and there has been a boom in local currency debt funds heavily influenced by US dollar weakness, the short-term outlook is far less certain. “As the US dollar recovers, local currencies offer less and make local investments more challenging. Optimally, a fund manager should only invest locally if the local yield is so compelling, as to compensate for the higher volatility from FX,” says Raphael Kassin, head of emerging markets fixed income at Credit Suisse.

As John Cleary, managing director of Focus Capital, admits, the strengthening dollar was a surprise that led his firm to sell off most of its local currency EMD exposure earlier this year. Many other managers have also reduced their exposures during the year. Payden & Rygel has had as much as 40% of its EMD exposure in the past in local currency but is now down to 20% with no plans to increase this at the moment, according to Panait. Pioneer had a peak of 17% of its EMD mandates in local currency but started reducing exposure last year and is now down to 6-7% according to Syzdykov. “Right now with increasing inflationary pressures and the volatility seen in financial markets, appreciating currencies such as the Russian rouble and Indonesian rupiah are no longer so attractive in terms of their risk/return trade-offs as strategies for generating outperformance,” he explains.

Western is not investing at all in local currency, according to Story, partly because of its negative view of the macroeconomic environment, but also because its own clients and prospects are not yet comfortable with local currency bonds. With volatile financial markets and correlations across asset classes increasing dramatically, it is holding off from adding any risky assets, which would include local currency bonds.

But for some active managers, the extra volatility is itself a positive factor. Booth says: “The local currency debt markets are larger and more liquid now, but also have more speculative money there. So after years of being less volatile than hard currency, we are now seeing more volatility and hence more alpha potential. It is fantastic if you are an active manager - we make more money when markets are volatile.”

It is not just the economic and market views that are an issue for managing local currency debt. “You need to be a bit like Indiana Jones with local currencies and to bring your bullwhip with you,” says Marber. The infrastructure is still being developed and in many cases, trading systems do not exist and issues include custody, foreign exchange, withholding taxes and most of all, the underlying liquidity of the marketplace.

The World Bank is encouraging the development of local bond markets with the Gemloc programme it is undertaking in conjunction with PIMCO to develop and manage investment strategies that will promote institutional investment. As Tzemach explains, this incorporates a local currency index that takes a broader and more inclusive view of the EM investment universe, including frontier markets.

Emerging market corporate debt

While the hard currency sovereign debt market is declining rapidly in size, issuance in dollar denominated emerging market debt is now dominated by companies, accounting for over 60% according to Michael Story of Western Asset Management. As a result, JPMorgan’s Corporate Emerging Markets Bond index (CEMBI) family may become a replacement for its sovereign indices, the EMBI family. Western Asset Management makes the point in a recent note that the CEMBI Broad index is actually considered to be a higher credit quality than its sovereign counterpart.

Historically, corporate debt had been subject to a ‘sovereign ceiling’ on the upper bound on ratings determined by that of the country it operated in. The logic for this was the risk of expropriation of private assets or higher taxes by countries facing repayment difficulties. But academic evidence pointed to the fact that while sovereign risk increases corporate risk, there was no support for the sovereign ceiling hypothesis. As a result, Standard & Poor’s relaxed its policy in 1997 and Moody’s followed in 2001.

Multinational corporations headquartered in emerging countries generate their own foreign exchange through international trade. Key sectors in the hard currency denominated debt markets include energy production, basic industry and metals and mining. The fortunes of these can be decoupled from that of their host country. Other large issuers include telecommunications companies and banks. As Western points out, the implication of this is that “the analysis of systematic risk is declining in importance while the analysis of idiosyncratic risk in increasing in importance.”

As a result, bottom up stock selection becomes of increasing importance for hard currency debt investment rather than top-down macro-economic analysis. Story argues that in many cases, the spreads are high even after taking account of credit.”It may be because there is a lack of focus on emerging market corporate credits by the rating agencies,” he says.

“A lot of emerging market bonds may not be re-rated as often as developed market companies.”

The future of EMD

Local currency sovereign debt and corporate debt, both hard ­currency and local, will become increasingly the mainstays of EMD investment. As Western’s Story admits, while the development of local markets is still nascent, it is not going to scale back because of the volatile market movements seen in the third quarter of 2008. “It is a function of the real need from local pension funds and the requirement for countries to be able to fund themselves in a more flexible manner,” he says. “It is a lot like we were 10 years ago in hard currency EMD. The key to management is to have very diversified portfolios.” The issue for institutional investors however, may be to be able to choose fund managers who are not just taking a general view of appreciating currencies against a declining dollar.