Income-hungry UK investors have left few stones unturned over the past few years. But one corner of the market that has largely escaped their attention – despite growing recognition as an asset class in its own right – is emerging markets debt. It has performed strongly and offers some very attractive yields, yet many advisers remain reluctant to recommend it and emerging market debt fund sales are well below those of other income categories.
The case for EM debt
Emerging market (EM) debt made its debut on international capital markets more than 20 years ago with the launch of the Brady Plan, which aimed to help mainly Latin American countries recover from the debt crisis of the 1980s. As emerging market fiscal and monetary policy has become more robust, emerging market debt has gone from being a stop-gap to an asset class in its own right. Today, it's worth more than $5 trillion.
The investment case for emerging market debt echoes the arguments favouring emerging markets generally: their economies are growing much more rapidly than those of developed countries, supported by solid fundamentals such as positive demographics, economic reform and liberalisation, improving governance, growing industrialisation and strong demand. Indebtedness generally is low compared with the west – average debt to gross domestic product (GDP) levels are forecast to be 35 per cent of GDP by 2013, compared with 119 per cent for advanced economies, while emerging market companies are in a similar position of balance-sheet strength.
"The theory is that as these nations grow in power and prosperity their currencies should become more valuable, leading to gains for sterling investors. Investing in the bonds issued by the governments and companies of emerging nations offers investors the opportunity to benefit from growth in emerging markets, but without the same level of volatility as stock market funds," comments Meera Patel, senior analyst at Hargreaves Lansdown.
While emerging market debt is not immune to global economic volatility, the resilience of the asset class has been proven through several financial crises, including that of 2008. In fact, emerging market fixed-income assets have generated cumulative total returns of between 20 per cent and 40 per cent since mid-2007, outperforming all other bond sub-classes.
Go local
Emerging market debt investments can be divided into three distinct sub-sectors: US dollar-denominated debt, as measured by the EMBI Global Diversified index; US dollar corporate debt tracked by the CEMBI Broad Diversified index (both are often referred to as external bonds); and local-currency sovereign debt measured by the GBI-EM Global Diversified index.
Most fund managers agree that the most attractive opportunities lie in local-currency EM debt, which offers further diversification away from hard-currency sovereign bonds, plus the attraction of higher yields and shorter duration (which measures the sensitivity of bond prices to changes in interest rates). That should provide some insulation in an environment of rising US Treasury yields.
Brett Diment, head of emerging market debt at Aberdeen, says many investors continue to focus purely on US-dollar-denominated emerging market bonds, overlooking the opportunities in local currency and credit markets. "Emerging market local-currency debt has exposure to currency and interest rate dynamics and offers broad geographical diversification, as well as a natural hedge against US dollar weakness," he says.
Thanasis Petronikolos, manager of the Baring Emerging Markets Debt Local Currency Fund, agrees, saying local-currency emerging-market debt offers some of the most attractive risk-adjusted returns around.
Barings highlights that as long as investors continue to search for yields in the current ultra-low interest rate environment, the case for emerging market debt will remain strong, as coupon yields are attractive at around 6 per cent. Even though 80 per cent of emerging-market sovereign bonds are investment-grade, yields are still markedly higher than their developed market counterparts, as the table shows (below).
High yields on EM funds | ||||
|---|---|---|---|---|
| 10-yr bond yield (%) | Inflation year-on-year (%) | Real yield | Credit rating | |
| Brazil | 12.8 | 6 | 6.8 | BBB+ |
| Colombia | 8.1 | 3.2 | 5 | BBB+ |
| Eqypt | 15 | 10.7 | 4.3 | BBB- |
| Hungary | 7.3 | 4.1 | 3.2 | BBB- |
| Indonesia | 8.3 | 6.8 | 1.4 | BB+ |
| Malaysia | 4 | 2.4 | 1.6 | A+ |
| Mexico | 7.6 | 3.6 | 4 | A |
| Peru | 6.3 | 2.2 | 14.1 | BBB+ |
| Poland | 6.4 | 3.6 | 2.8 | A |
| Russia | 7.8 | 9.5 | -1.7 | BBB+ |
| S. Africa | 8.8 | 3.7 | 5.1 | A+ |
| Thailand | 3.6 | 2.9 | 0.7 | A- |
| Turkey | 9.4 | 4.2 | 5.3 | BB |
| US | 3.3 | 2.1 | 1.2 | AAA |
| UK | 3.5 | 4.4 | -0.9 | AAA |
| Germany | 3.2 | 2.1 | 1.1 | AAA |
| Japan | 1.2 | 0 | 1.2 | AA- |
Source: S&P, Bloomberg, 22 March 2011. Notes: Credit rating is from S&P. | ||||
The risks
The picture is good for default rates, too. According to figures from Aberdeen Asset Management, the default rate for emerging markets corporates was 3.5 per cent in 2009 – and three-quarters of those came from the Kazakh banking sector. This compares with a 4 per cent default rate for all rated global corporate bonds and 5.7 per cent for US corporates.
While these figures do much to disprove perceptions that the asset class is more risky than other areas of the investment universe, emerging market debt is certainly not without risks. Emerging market bondholders face the same issues of transparency and corporate governance as emerging market equity investors, although market liquidity and capital structure are areas of greater concern. There is also the issue of volatility, currency fluctuations, political upheaval and inflation. Accounting standards in emerging markets tend to lag those of developed economies, while analyst research on these vehicles is thin on the ground.
Given these risks, some financial advisers remain cautious on the sector. Patrick Connolly of wealth manager AWD Chase de Vere says: "The strong returns achieved in recent years should be seen as a warning sign rather than a buying opportunity. Investors too often jump into an investment after it has already performed well and is nearing its peak."
Tim Cockerill of Ashcourt Rowan adds that, while there is no doubting that the returns from EM debt funds over the past two to three years have been good, the closing of the yield gap between the EM debt markets and the developed debt markets could mean there is less room for further gain, especially if interest rates in the developed world start to rise.
Mr Connolly is also concerned about the issue of currency risk, which he says can have a big impact on fund performance if returns are not hedged back to sterling. However, Mr Diment, who manages the Aberdeen Emerging Market Fund, says that, while the fund hedges its exposure to US-dollar-denominated bonds back to sterling, this is not done with emerging market currency-denominated bonds as they expect most emerging market currencies to appreciate against sterling, providing enhanced returns.
While some analysts have argued that emerging market bond exposure should be seen as an equity holding rather than a substitute for existing fixed-income exposure, Mr Diment is adamant that the asset class should be part of an investor’s broader fixed-income exposure. He says: "UK investors are definitely underexposed to this asset class. Emerging markets now account for 20 per cent of the global corporate bond market and consequently can no longer be overlooked in a diversified credit portfolio."
Inflation: blessing or curse
Fixed-income investors fear inflation for two reasons: it reduces the real yield on a bond and rising market yields cause the bond price to fall.
Emerging markets often allow inflation to run at higher rates than developed markets. "A eurozone-based investor who buys a US dollar-denominated emerging market bond from Russia, say, may need to worry about the inflation rate in three countries: their own, the US and Russia," says Dan Morris, market strategist at JP Morgan Asset Manager.
The impact of inflation is not always negative, though. Mr Morris explains: "It is partly because emerging markets have higher inflation that yields are high relative to most developed markets."
For example with local currency emerging market sovereign debt, an increase in issuing country inflation translates fairly directly into increases in the yield on the debt.
