The emerging bond opportunity

Clearly, there is an opportunity in emerging market debt. But where you invest within that broad universe can make all the difference.

Improving fundamentals

Emerging market bonds have been one of the best-performing asset classes over the past two years, although they have suffered significant outflows lately as risk sentiment across the globe has deteriorated in the wake of the euro debt crisis.

Nevertheless, credit fundamentals and structural growth prospects for this asset class remain very solid. "The drop in prices can therefore be seen as a good opportunity to add exposure with a long-term perspective," says Alessandro Ghidini, manager of the JB Emerging Market Inflation-Linked Bond Fund.

Despite the short-term correction, analysts argue that if anything, the euro-periphery crisis has highlighted how much the credit quality in emerging market countries improved since their own debt crises in the 1990s.

"Emerging market bonds offer investors the advantages of credit quality and diversification away from areas traditionally regarded as safe - such as Europe - which we now know are anything but safe," says Johan Jooste, portfolio strategist at Merrill Lynch Wealth Management.

The figures are certainly telling: emerging markets' average fiscal deficit (that is, the shortfall between state revenue and state spending) currently stands at 2 per cent of GDP, compared with 7.5 per cent for developed markets. Many of these economies also have been boosted by the high commodity prices of recent years, while as a group, emerging markets have increased their currency reserves dramatically. Today almost half of emerging market countries are net lenders to the world - see the table below.

Table: emerging markets become the creditor nations

Source: JPMorgan, "A reversal of Fortunes", September 2011

"The world is only now waking up to these numbers and so too are the credit rating agencies," says Helen Williamson, head of emerging markets debt at First State Investments.

The strong ability of emerging markets to repay their debts is reflected in their improving credit ratings - with the average rating of emerging markets countries on a long-term upward trend. In 1994 the average rating was BB-; by 2010 the average rating has risen to investment grade BBB-. In contrast, developed markets have seen a number of downgrades over the past seven years, which most recently included the US and several European countries.

The demographic factor

Fiscal measures aside, there is another major factor playing in favour of emerging markets and their bond markets: demographics.

"Advanced economies with their ageing populations have to cope with rising pension liabilities which are not included in debt-to-GDP ratios but are increasingly taken into account by credit rating agencies. Most emerging market countries have younger populations and enjoy a 'demographic dividend' and higher growth rates," says Ms Williamson

The rising health and pension costs of an ageing population means advanced economies' financing requirements are considerably higher than those of emerging markets. Next year the gross financing needs of emerging countries is expected to account for only about 8 per cent of their GDP, while the developed world would have to raise over 27 per cent of GDP.

Simulations by the International Monetary Fund (IMF) and Organisation for Economic Co-operation and Development (OECD) suggest that the effects of ageing alone will increase debt ratios in the developed world by 50 percentage points of GDP over the next 20 years. For the advanced G20 economies, the government debt/GDP ratio is projected to rise from 100 per cent in 2010 to 150 per cent in 2030. Over the subsequent 20 years, debt ratios for these countries are expected to rise further, increasing to 275 per cent of GDP by 2050. (Of course, this situation was not helped by the credit crisis, which has further worsened balance sheets.)

The only outcome for the developed world will be spending cuts and rising pension ages. But measures such as these are politically unfashionable for governments clinging on to power by small margins. In the eurozone, for example, most governments have very thin majorities, which makes bold and unpopular measures difficult, not least when elections are coming up. "It is doubtful whether populations in the euro-periphery will endure several years of austerity and support the governments advocating this austerity," comments Ms Williamson.

Yet hard decisions need to be made, and Ms Williamson adds that part of the reason the US credit rating was downgraded was because leaders could not come to a consensus on healthcare issues and the country's pension liability.

Where to invest

While analysts expect emerging market credit ratings to continue their upward trend, despite some downgrades in the Middle East country, the asset class has certainly not become risk-free.

"The disadvantages are that some of this good news is already priced in, and if the US economy trips up, the rest of the world will be impacted. Emerging market bonds will also be dragged down in the maelstrom," says Mr Jooste.

Ms Williamson highlights the main risks as the occasional contagion from the euro-periphery crisis and lower commodity prices due to slower global growth.

Given these risks, you need to be selective about where you invest as different funds will invest in different flavours of emerging market debt. In the last few years, local-currency debt has been increasingly popular, but as risk aversion rises, dollar-denominated debt is proving better from a return perspective. Tim Cockerill of Rowan-Dartington comments: "In a world facing some very major issues, assets once considered safe havens have become less secure, because their prices have risen too high. Investors are now looking for other safe havens." Gold is a good example of this; it's risen strongly over the past ten years, but has increasingly found it hard to make new highs.

The vast liquidity of the US makes dollar-denominated assets look a prime safe haven as the eurozone dithers. Combine this with the socio-economic attractions of emerging markets and the result is pretty compelling. "You can hold an asset where there is a combination of attractive features, a good yield, low risk corporate and sovereign debt issuers, strong underlying economies and dollars," says Mr Cockerill.

Mr Jooste has similar views, saying that investors should remember the prime purpose of bonds is to diversify portfolios and generate a steady income over time. "So choose well-diversified emerging market bond funds with track records, preferably invested in sovereign rather than corporate bonds, and resist the temptation to try and pick specific countries."