Going local as dollar tightens

This year has seen a summer of discontent for fixed interest markets. Concerns about the ability of borrowers to repay their loans in the sub-prime housing market in the US and the increasing cost of capital in much of the developed world has raised concerns about credit markets. This has led to greater caution among lenders. At the end of July, for example, Chrysler postponed a $12bn (?8.76bn) loan deal and banks failed to sell £5bn (?7.39bn) of senior loans to fund the buy-out of Alliance Boots. Credit concerns Emerging market debt has not been immune from these credit concerns. In early summer, dollar denominated debt had reached spreads over US Treasuries of just 150 basis points. This widened to 175 basis points in early June and 190 basis points in mid-July. In the last two weeks of July, spreads widened by another 40 basis points. Fund managers, however, stress that spreads on local currency debt have not been impacted to the same extent. While spreads widened over the summer, they are still narrow compared to 10 years ago. Alan Bridges, senior portfolio manager at ABN Amro Asset Management, says spreads between the JP Morgan Embi index and US Treasuries reached 1,500 basis points in 1998 during the Asian crisis. By 2002, spreads had narrowed to 1,000 basis points before tightening much further over the past five years. Given this tightening of spreads and therefore the capital gains that have already been delivered, can investors expect strong positive returns from emerging market bonds in the future? Kieran Curtis, manager of the Aviva Morley Emerging Market Debt fund, says there are unlikely to be the same returns of the past few years unless spreads widen significantly or US Treasuries rally. “It is harder to find investment opportunities than in the past. After the first three months of 2006, for example, we realised if spreads continued at the rate they were going then they would end the year at a premium to US Treasuries.” Local potential There is wide agreement among fund managers that local currency denominated debt offers better investment opportunities than dollar denominated debt. “In the short term, spreads may widen further,” says Mr Bridges. “Nevertheless, over the long term, we believe there are investment opportunities among dollar denominated debt, but especially among locally denominated debt.” Mr Bridges says local currency denominated debt is increasingly liquid and is higher yielding than dollar denominated debt. He points to the fact that 10-year Mexican dollar denominated debt has a spread of 100 basis points whereas Mexican local currency denominated debt has spreads of 300 basis points. The recent widening of spreads, says Jeff Grills, co-manager of the JPMF Emerging Markets Bond fund, means dollar denominated debt is on average around 10 to 15 basis below fair value. “Spreads may widen by another 25 basis points but there is little prospect of them widening another 100 basis points.” But he adds that local currency debt offers a compelling investment. “The average yield on the local currency index is 7.6 per cent. We have an average yield on local currency debt in our fund of 10.5 per cent. Given that 10-year Treasury yields are at 5 per cent, you can double the yield by investing in local currency debt.

‘There are different return dynamics for local currency rather than dollar denominated debt. The recent volatility in credit markets has impacted on dollar denominated debt more than on local currency debt’ - Michael Hasenstab, Templeton Emerging Market Bond fund

“Local debt has also benefited from strengthening currencies. This has been contributing around 30 per cent to returns with 70 per cent of returns coming from yields. In the future, however, around 85 per cent of returns should come from yield. “Our fund has a weighting to local currency debt of 41 per cent. This is the highest weighting the fund has ever had.” Michael Hasenstab, manager of the Templeton Emerging Market Bond fund, says the greater prominence of local currency debt is presenting the opportunity to enhance returns and improve diversification in a portfolio. “There are different return dynamics for local currency rather than dollar denominated debt. The recent volatility in credit markets has impacted on dollar denominated debt more than on local currency debt.” JPMorgan Fleming’s Mr Grills says there is a strong fundamental underpinning of emerging market debt. A key part of this has been the strong commodity rally of the past five years. “Countries had trade balance deficits in the late-1990s but many have surpluses now because the value of exports have exceeded imports,” says Mr Grills. “This is translated into GDP growth. There has also been reduced capital flight and a strengthening of currencies. This has led to current account surpluses. “Governments have reduced their level of borrowing compared to previous cycles. This time, fiscal deficits have been reduced and many governments have fiscal surpluses. Debt to GDP in emerging countries has fallen by around 25 per cent over the past seven to eight years. Tighter spreads “Emerging countries have been buying back debt. Local denominated debt has been flat while dollar denominated debt has been net negative. There has been less issuance of dollar denominated debt than payments for the first time since the early-1990s. This has led to tighter spreads.” Another fundamental strength, says Mr Grills, is the lower inflation in emerging countries. Aggregate inflation is now 4 per cent to 5 per cent compared to 10 per cent to 11 per cent five years ago. “With lower inflation, some emerging countries are offering attractive real yields on bonds. Turkey, for example, had inflation of 70 per cent five years ago. Now inflation is around 8 per cent and yields are 18 per cent. This means real yields are at 10 per cent. “In Brazil, inflation has been 3 per cent while the target is 4 to 5 per cent. In contrast, yields are at 11 per cent on Brazilian bonds. Bonds will have to enjoy capital growth for the yield gap to close.” Templeton’s Mr Hasenstab is optimistic about the outlook for emerging market debt because of the economic growth being generated, especially in Asia. This is allowing governments to pay back debt and improve the credit rating of countries. He argues that Asia has undergone some delinkage from the US. “In the past, a slow down in the US would have had a greater effect on Asia. The reduction in trade to the US, however, is being offset by increased intra-regional trade in Asia and growing domestic consumer demand, as well as a pick up in demand from Europe.” Mr Hasenstab says there is greater diversification within emerging markets debt as it is no longer a one directional play. He can play short or long duration depending on his view of interest rates. In some cases, he might hedge the currency or interest rate risk. Even if spreads have tightened, there are some opportunities to profit from currency appreciation.

‘Venezuela has a deficit even though its oil price is at a high level. There is still a large supply of bonds in Argentina’ - Kieran Curtis, Aviva Morley Emerging Market Debt fund

Mr Grills says the biggest risk to emerging markets bonds is a global recession. But Mr Grills does not believe this is likely and does not believe the cost of capital will rise significantly in emerging countries. But he adds that not all markets offer attractive value. While Ecuador spreads are on 650 basis points, he does not believe the risk return profile is attractive. “Iraq is trading on spreads of 600 basis points and it is attractive in terms of the level of debt forgiveness it has been promised.” But there are the well known political and security concerns that means Mr Grills believes it is not an attractive market. This shows that emerging market bonds are not a homogeneous group. Mr Curtis highlights Argentina and Venezuela as examples. “At the end of last year, we took an underweight position in Venezuelan and Argentinian bonds. Venezuela has a deficit even though its oil price is at a high level. There is still a large supply of bonds in Argentina. The data for the next couple of years may suggest bonds appear relatively cheap but the country has problems with inflation. Driven by diversity “There is more diversity across local currency debt. Some central banks have been reducing rates while others have been increasing rates. They are less sensitive to actions by the Federal Reserve and moves in US Treasuries.” ABN Amro’s Mr Bridges says the investment strategy of the ABN Amro Global Emerging Bond fund is changing slightly following the departure of Raphael Kassin to Credit Suisse Asset Management (CSAM). Paul Abberley and Mr Bridges took over the management of the fund in April and will run it until Chris Kelly and Tomaz Stadnik join from CSAM at the end of August. The fund has out-performed the JP Morgan Embi Global Diversifed index over one, three and five years. Mr Bridges says the fund will continue to be managed as a total return vehicle when the new team arrive. But over the past few years, the fund has focused on Latin American dollar denominated government bonds. “This focus has led to the fund delivering strong performance,” says Mr Bridges. “But we are now diversifying the fund by increasing exposure to Europe and Asia, corporate bonds and local currency denominated bonds. “Raphael was able to deliver alpha from the focus on Latin American debt but we believe we can add value by diversifying our sources of alpha. A large proportion of the fund was invested in just two markets – Venezuela and Argentina.” Mr Bridges says the performance of the fund over discrete calendar years has been volatile. This volatility should be reduced because of the new diversification. Mr Bridges adds that the recruitment of Chris Kelly will aid diversification as he has specialised in corporate bonds. Mr Curtis, who manages the Aviva Morley Emerging Market Debt fund with Jerry Brewin, says there are different pillars to its management. The first pillar takes a top down view, including analysis of debt to GDP, the current and trade balances, reserve coverage for imports and debt payments and the effect of demand from larger economies on emerging markets with which they trade. The team also takes a bottom up approach. They analyse the relative attractiveness of the price and yield of bonds. The fund has out-performed the JP Morgan EMBI Global Diverisfied index over one year but under-performed over the past three years. This is partly because the fund has expanded its investment universe by including locally denominated debt and corporate debt. Three-step process Mr Grills, co-manager of the JPMF Emerging Marks Bond fund, which has out-performed the index over one, three and five years, says there is a three-step management process. The first step is a country fundamental model. The model analyses fundamental factors to produce a valuation for bonds in each country. “The model, for example, may evaluate that Venezuela bonds are 80 to 90 basis points under-valued. “But the fund is not just run on a quantitative basis. There is also a qualitative assessment by Gunter Heiland, myself and the team. We look at whether there are any factors affecting valuations that the model has not picked up. Ecuador, for example, was coming up cheap as it was benefiting from a high oil price. But we believed the risk return profile made the Ecuadorian debt less compelling than other countries’ debt. “The third step is a risk analysis of the portfolio. We look at the correlation between different pieces of debt held within the portfolio and how our holdings affect the overall risk of the portfolio.”