A good time to invest if you know the risks

The development and maturity of emerging market debt over the past few years was encapsulated by the upgrading of Brazil’s sovereign debt at the end of April by Standard & Poor’s. The debt was given an investment grade rating of BBB-. The rating upgrade reflects the general economic growth and increasing financial strength of emerging markets and thus the reduced threat of defaults. Emerging market debt enjoyed a sustained period of positive returns until 2007 as spreads with US Treasuries narrowed. As yields fell, so investors in emerging market debt benefited from capital growth. The narrowing of spreads and fall in yields were driven by a combination of factors, including the economic growth enjoyed by emerging markets in recent years, the related strengthening of current and fiscal accounts and increased allocations to emerging market debt by global investors. China, for example, has been enjoying double digit economic growth and India is expanding at an annual rate of around 8 per cent. Brazil and Argentina were growing at annualised rates of 6.4 per cent and 8 per cent respectively at the end of 2007. This strong economic growth has boosted government finances, with India now having reported foreign exchange reserves of around $313bn (E203bn). Jerome Booth, head of research at emerging market specialists Ashmore, says that while the US has reserves of $45bn, Brazil has $200bn, Russia has $600bn and China has $1.2bn. Andrew Bosomworth, senior portfolio manager at Pimco, says Russia was receiving receipts of $1bn a day when the oil price was $97 a barrel. Brazil is in a similar situation with the export of iron ore and copper, says Mr Bosomworth. “At the moment, 50 per cent of global growth is from emerging markets,” says Mr Booth. “We believe 80 per cent could come from emerging markets. Emerging markets believe they are not being affected by the credit crunch. There are still IPOs in emerging markets, for example.” Debt not immune Emerging market debt, however, has not been immune to the credit crisis affecting the US and other developed economies. Nevertheless, while spreads on emerging markets debt on average more than doubled from 2007 to 2008, this was not as wide as debt in developed countries. Michael Hasenstab, manager of the Templeton Emerging Market Bond fund, says spreads on the JP Morgan index widened from 151 basis points on 1 June 2007 to 339 basis points by mid-March 2008. But from mid-March 2008, emerging market debt spreads started to narrow and reached 282 basis points by the end of April. Although corporate bond spreads in developed markets also started to narrow after the rescue of Bear Stearns and central banks promised to provide greater liquidity to the markets, investment grade spreads had already reached record levels. Mr Bosomworth argues that spreads on emerging market debt widened because of the rise in risk premiums. “Debt in Poland and Slovakia widened relative to government bonds in France and Germany, even though they are in the European Union.” Nevertheless, the index spreads are the average and hide differences in performance. Bernt Tallaksen, joint manager of the Thames River High Income fund, says countries with larger current account surpluses have been generally less affected by spread widening during the credit crunch. Those countries afflicted by high or rising inflation have generally suffered greater spread widening. “Growth dynamics, inflation dynamics and risk aversion have been the key drivers,” says Mr Tallaksen. “Emerging markets have benefited from their relative lack of exposure to US subprime and, in many cases, strengthened fundamentals.” Some corporate bonds in emerging markets have not escaped so lightly. Mr Tallaksen says corporate bond spreads have widened by as much as 500 basis points and in some cases even more. This comes after a number of years of strong performance of the asset class. The performance of the JP Morgan EMBI Global Diversified index and emerging market debt funds in the table, however, are impacted by movements in exchange rates. Some funds are denominated in currencies, such as the US dollar, other than euros and therefore may be at risk of losses through currency movements. Funds that invest in local currency debt may again benefit or suffer from movements in the euro against other currencies. It is important to check the exposure of funds to exchange rate movements before investing. Reasons for optimism The widening in spreads over the past year prompts the question of whether emerging market debt is now offering attractive value. There are technical and fundamental reasons why fund managers believe the asset class provides some attractive investment opportunities although there are also risks on the horizon. One reason for optimism are the flows of assets into emerging market debt. Domestic investors are still the main holders of local currency emerging market debt but the proportion in the hands of foreign investors is increasing. It has been estimated that foreign investors’ share of local currency debt has risen from below 10 per cent to closer to 20 per cent over the past few years. JP Morgan estimates that total flows into local currency and hard currency emerging market debt has increased to around $30 billion a year. From the start of 2008 to early April, around $6.6bn had been invested in emerging market debt by foreign investors. JP Morgan says the proportion of money invested by foreign investors in local currency as opposed to hard currency debt was just 3 per cent in 2004. This rose to 20 per cent in 2005, 27 per cent in 2006, 65 per cent in 2007 and 90 per cent in the first three months of 2008. Continued strong flows may see yields fall and investors benefit from capital gains. The growing interest among foreign investors in local currency debt comes as this forms an increasing proportion of total emerging market debt. If current trends were to continue, external debt might disappear in five to 10 years’ time. But as Mr Bosomworth points out, as some countries pay off their external debt, other nations, such as in Africa, will issue hard currency debt as they need to raise capital. The economic growth of emerging markets is also behind the optimism of fund managers. These reflect the top down macro economic approach that many emerging debt funds adopt. A number of emerging markets have profited from the high price of commodities as they are exporters. But Mr Bosomworth says the economic strength and current account surpluses of emerging markets are also the result of the implementation of orthodox monetary and fiscal policies. These policies should lead to lower inflation and thus interest rates, which may also result in reduced yields on bonds. This should generate capital growth for investors. “In Brazil, for example, interest rates have been between 12 and 14 per cent,” says Mr Bosomworth. Emerging market debt also still offers some attractive yields, says Mr Bosomworth. Brazilian two-year government bonds, for example, are yielding 13.8 per cent. Other bonds are attractive for different reasons. He says Russian 10 year government bonds are yielding 7.5 per cent. “The yield is likely to rise and therefore investors may suffer capital losses. But these bonds may be attractive for potential currency appreciation.” The opportunity for appreciation is particularly the case where currencies have been pegged or linked to the US dollar but are now facing inflationary pressures. Such markets include China and Middle Eastern countries. “There will have to be an adjustment of emerging market currencies against the US dollar,” says Mr Booth. “The only question is how this will happen.” This could include a gradual appreciation over a period of time or a one-off adjustment. Therefore, there are different ways in which managers try to generate returns from emerging market debt. “When we select bonds, we decide whether they will be attractive in currency, interest rate or sovereign spread terms,” says Mr Hastenstab. “Thus, we invest in markets for different reasons. Mexico will be affected by the US slow down. Over the long term, however, we expect Mexican interest rates to come down. This means bond yields will come down and investors should benefit from capital appreciation.” Currency appreciation Currency appreciation is one of the tools countries will use to tackle one of the main threats facing emerging markets, which is inflation. While a number of countries have profited from high commodity prices, this is also driving up the rate of inflation. There have been estimates that the Saudi Arabian riyal may have to revalue by 15 per cent or more to impact on inflation. Mr Booth is confident about their ability to manage and tackle inflationary pressures. “It is wrong to say emerging markets’ central banks do not understand the threat of inflation. If they stop buying the US dollar, their currencies will rise. As well as letting currencies appreciate, emerging markets may tighten interest rates to tackle inflationary pressures.” Mr Bosomworth also says currency appreciation offers a long-term investment opportunity. “Measuring currencies on a power parity basis shows that many emerging markets currencies are under-valued while the euro looks expensive. Governments are likely to allow the free floating of currencies or adjustments.” Mr Hasenstab says emerging markets may have to raise interest rates in the short term to combat inflationary pressures. “If successful in combating inflation, long dated yields will probably not rise much because of confidence about the economic outlook. Therefore, there may not be capital losses on long dated bonds.” Old habits die hard Mr Bosomworth argues that one risk confronting emerging markets is if they are derailed from continuing their orthodox fiscal and monetary policies. “There is always a risk that emerging markets may revert back to their old spending habits. This may be triggered, for example, by trying to meet social economic goals, such as parts of their population struggling to eat because of the rise in food prices, especially rice. We have seen this in Egypt where the government has maintained a subsidiary on food even though it had previously stated it would scrap it.” Another risk, says Mr Bosomworth, is if the perception that emerging markets can decouple from the US economy turns out to be a fallacy and they will be significantly impacted by an economic slow down in developed markets. The threat includes the possibility of a greater economic slow down in developed economies than expected. “If emerging markets are significantly affected by the slow down in the US, this will affect their current account surpluses and their rate of economic growth will decline,” he says.

‘There will have to be an adjustment of emerging market currencies against the US dollar’ - Jerome Booth, Ashmore	‘There is always a risk that emerging markets may revert back to their old spending habits’ - Andrew Bosomworth, Pimco

“The question is what would happen to the orthodox fiscal and monetary policies and whether they would be put on the back burner. But there is a belief that internal demand and growth in emerging markets will offset some of the US economic slow down and data suggest that governments are sticking to their orthodox policies. Hungary has been raising interest rates even though it looks like it is heading for recession so it can combat inflation,” says Mr Bosomworth. “The threat is more on the fiscal than monetary side as governments may increase their spending. This may add fuel to the current inflationary pressures.” Mr Tallaksen says that while the down turn in the US will lead to a modest slow down in many emerging markets, he adds that “strong domestic demand and the high commodity prices make them better able to withstand a developed market slow down than in the past. Asia in particular benefits from strong domestic demand and Eastern Europe, Middle East and Africa from the relative resilience of Western European growth.” While rising commodity prices have helped fuel inflationary pressures, a substantial fall in prices is also a potential threat for emerging markets that have benefited from increased income and thus strengthened current accounts. Nevertheless, with the widening of spreads, Mr Hasenstab says emerging market debt offers better value than last summer. “We were positioned quite defensively a year ago.” But while he argues that there are more opportunities now he says he is still being selective in which emerging market debt the fund holds. He adds that the greater differentiation in performance between emerging market debt will continue. “Two of the factors we evaluate are whether a country has a current account surplus and a low to debt GDP ratio. Those emerging markets with a large current account surplus and a low debt to GDP ratio will be less affected by the global economic slow down. ” Mr Tallaksen says the repricing of sovereign and corporate debt over the past six months means that “after quite a lengthy dry spell lenders of capital can once again get well paid for taking risks. The best investment opportunities are currently in hard currency corporate debt and local currency sovereign debt. “So far, currency appreciation has been the major contributor of returns but going forward we believe we will get an equal return from currency appreciation and spreads narrowing.” But Mr Tallaksen agrees with Mr Hasentsab that there are only selective investment opportunities. “This is a good time to slowly accumulate and cherry pick debt.”