Piers Bolger believes that emerging market debt will continue to grow in prominence and provide an alternative debt solution to developed market economies.
With ongoing global uncertainty and the need for developed market economies to grow their balance sheets in order to provide financial stability, bond markets have rallied extensively over the past two years.
This is a trend that could continue for some time.
Given this backdrop, emerging market bonds have increasingly become a source of opportunity for investors to consider as an alternative, and additional fixed income investment to developed market investments within a broader fixed income portfolio.
Emerging market sovereign issuers have a long history of involvement in international capital markets through the issuance of US dollar or other major currency denominated bonds to fund their domestic operations.
Emerging market debt was historically a small percentage of global bond markets as primary issuance was limited, data quality was poor, markets were illiquid and economic and political crises were often a regular occurrence.
However, since the advent of the Brady Plan in the early 1990s, emerging market debt issuance has increased dramatically, albeit the sector continuing to be more prone to crises than other debt markets – eg, Mexican crisis in 1994-95, East Asian crisis in 1997, Russian crisis in 1998, and Argentine economic crisis in 2001-02.
However, over the past decade improvements in macroeconomic fundamentals, institutional structures and governance have enabled emerging market central banks to significantly increase the issuance of major currency and local currency bonds.
Accordingly, demand has been particularly strong from domestic buyers such as local banks, as well as from pension plans experiencing rapid expansion.
For emerging market governments and institutions, the issuance of local currency debt has reduced exposure to external risks, as well as addressed financing imbalances that have been at the centre of past emerging market crises.
Over the past decade, emerging market countries have actively pursued policies of lowering their external debt burden through buybacks and reduced hard-currency refinancing. Several emerging market countries have even achieved the status of net external creditor.
Issuers have become less dependent on foreign capital flows, thus improving both policy flexibility and creditworthiness.
The extension and deepening of local currency yield curves has also been an equally important development for domestic investors and essential for asset/liability matching and efficient portfolio management.
Going forward, the development of local currency capital markets establishes a much stronger foundation for pricing of corporate bond issues.
Investor interest in local currency emerging market debt was also led by the rapid improvement in the macroeconomic fundamentals of emerging countries.
Among the major export-driven economies, foreign exchange reserves have increased tremendously through central bank isolation of trade flows.
These reserves provide the means to stabilise the exchange rate and avoid the cycles of hyperinflation and currency devaluation that had kept risk-averse investors out of the asset class.
In countries like China and Brazil, central banks have also funded counter-cyclical fiscal policy which has helped to maintain positive growth as developed markets contract.
Such stimulus spending is particularly important and useful in emerging market economies. These countries have huge infrastructure and development needs, which means that governments can spend on productive projects that will fuel future growth and investment.
Emerging market governments have also made significant headway in a number of areas such as the strengthening property rights, controlling fiscal spending and the free float of currencies.
Many emerging market countries have also come to realise the importance of an independent central bank with a transparent and clear inflation-targeting monetary policy.
Another significant positive development has been the expansion of domestic economies and the growth of the middle classes. These ‘new’ markets provide an important source of diversification that continues to support emerging market growth in spite of weak demand externally.
Diversification away from solely producing primary commodities or manufacturing for export has reduced contagion risks and lowered exposure to developed market contraction.
The bursting of the debt bubble in 2007 and the resulting deterioration in public finances across the developed world has led to a reappraisal of sovereign and credit risk, particularly in an emerging market.
Nevertheless, the global financial crisis showed that the emerging market hadn’t wholly shed the need to attract foreign capital in order to finance infrastructure development and economic growth.
During the past 12 months we continued to see the demand for US treasuries as ‘safe haven’, given the degree risk aversion across all financial markets.
The extra yield of emerging market bonds over US treasuries (the yield spread) has widened to reflect increased refinancing risks.
However, despite the intensity of the financial crisis in Europe and the slowdown in global growth, the finances of these countries remain relatively robust, and emerging market countries (to date) have not experienced the same levels of default and contagion that many investors expected.
Consequently, given the relatively strong fundamentals, emerging market bonds are now considered a strategic holding for an ever-expanding circle of investors.
In regard to achieving an exposure to emerging market debt, there are effectively two ways:
- US dollar bonds;
- Via local emerging market currency.
Emerging market US dollar bonds are essentially a credit asset, typically offering a yield pick-up over US Treasuries as compensation for taking on additional risk.
As outlined, emerging market sovereign issuers have seen a steady improvement in their creditworthiness in recent years due to large-scale structural reforms, including sound fiscal and debt management. Their credit profiles compare favourably to sovereign borrowers in the developed world – many of whom are likely to feel the effects of the credit crisis for years to come.
Through US Dollar bonds, investors have access to a higher number of sovereign credits. However, with greater variety comes a higher-risk credit profile.
Most of the 26 countries that raise debt exclusively in US Dollars are lower-rated, export-dependent nations whose economies are at an earlier stage in their transition to developed market status.
The average credit rating of emerging market dollar bonds is BB+, compared to A+ for local sovereign bonds. In terms of market weighting, Latin America and Russia make up more than a third of the sovereign dollar bond index.
This comes at the expense of Central and Eastern Europe – a region far better represented in local bond indices. Such differences in country and credit composition can have significant investment implications.
As developing economies have grown over the past decade, the volume of US dollar denominated corporate bonds outstanding has doubled to well over $200 billion.
Investors can choose from issuers based in any one of 19 countries operating across numerous industry sectors, including banking, consumer goods, industrials, mining, utilities and telecommunication services.
Around 80 per cent of this debt is investment grade, reflecting marked improvements in the way emerging market corporations manage their balance sheets.
Emerging market corporate bonds can also offer a way for investors to benefit from a number of secular trends shaping the global economy.
Increased infrastructure spending in the developing world is one of these. Many corporate issuers are companies that stand to gain from government-driven programs to improve transportation, power and water infrastructure.
Another way of gauging how effectively emerging market debt can bring diversification to a portfolio is by analysing their correlation profiles.
Although the credit crisis has caused many previously uncorrelated asset classes to move in lock step, both local and US dollar emerging market bonds have maintained their historically moderate correlation with most mainstream securities – particularly developed market fixed income.
Overall, the most notable aspect of investing in emerging market debt is that developing economies have, by and large, evolved into a group of reform-minded nations that generally boast high rates of growth and robust public finances. It is due to such developments that emerging market debt – comprising US dollar bonds, local currency debt and corporate bonds – is increasingly viewed as a mainstream (and growing) asset class.
Debt, deleveraging and deflation will be the recurrent themes in the Western world in the years ahead. Having borrowed too much, Western nations are in danger of being caught in a Japan-like deleveraging and deflation trap.
The best that central bankers will be able to do is to commit to low short-term interest rates for a very long period of time.
This will continue to provide opportunities for emerging market debt, and for investors to consider it as part of an overall fixed income exposure.
Accordingly, BTFG Research believes that emerging market debt will continue to grow in prominence and provide an alternative debt solution to developed market economies.
However, while the return opportunities may be attractive, we recommend that only those investors that appreciate the risks involved in investing in emerging market debt consider it as part of a broader investment and portfolio configuration.
Piers Bolger is head of research and strategy, advice and private banks at BT Financial Group.
