Nerves tested by correction

Despite positive performance over several years for most emerging market bond funds, they did not escape the market correction that hit equities and bonds in May and June. Indeed, risky assets generally suffered the most during these two months. Emerging market debt lost an average 2 per cent in May and another 1 per cent in June. But Jerome Booth, head of research at Ashmore Investment Management, says these declines compare well against developed markets. “The outlook is still positive for emerging market debt as there are inflows and little issuance,” says Mr Booth. “Governments are not issuing in the current market because they do not need the money. I would expect institutional investors to start allocating to emerging market debt again after the summer. Therefore, demand and supply factors favour emerging market debt.” A feature of the sell-off in May and June, says Mr Booth, was that many investors ended their carry trade. This is where investors seek to profit from interest rate differentials between countries. “This has affected especially Japan, New Zealand, Australia, Turkey, Hungary, Brazil and Iceland. This shows that developed as well as developing markets have been impacted.” One unusual characteristic, says Mr Booth, was the fact that local currency bonds fell more than dollar denominated debt. Usually, it is the other way round. Mr Booth says that during the sell-off in May and June, a lot of speculative money came out of emerging market debt. “There was $15bn (?11.87bn) to $20bn in the Brazilian forwards market, for instance. This was speculative money. In May, this went down to zero. Nobody was shorting the currency so there really was nothing in the forwards market and thus no speculative money. “At the same time, Brazilian exporters bought R7.2bn (?2.58bn) in the spot foreign exchange market. This is because they had too many dollars and were waiting for the chance to sell them. This shows there is not local panic. Furthermore, the Brazilian government has bought back $4bn of its debt.” Mr Booth says that once the markets calm down, local currency debt will perform well again. The potential demand, says Mr Booth, is shown by the inflows for major IPOs recently. “Bank of China recently attracted $100bn for its listing, which was 10 times over-subscribed.” Michael Discher-Remmlinger, manager of the Dit-Emerging Markets Bond fund, says he was cautious about emerging debt markets earlier this year and thus he took some profits. “We said in March that we expected some sort of correction in the markets. There was too much liquidity and no differentiation between credit quality. The global tightening of monetary policy, notably in the US, Europe and Japan, has led to a cyclical downturn for risky assets such as emerging markets bonds.” This prompted Mr Discher-Remmlinger to accumulate 7 to 8 per cent of his fund in cash. He also reduced interest rate duration. Nevertheless, Mr Discher-Remmlinger is optimistic about the medium-term outlook. He says that emerging markets have benefited from windfall revenues from high energy and commodity prices. Mr Discher-Remmlinger adds that countries such as Russia have been able to use this to reduce their debt burden. “We still like Brazilian debt and bonds in Russia. We hold the debt of companies in Russia that are close to and owned by the government.” Mr Discher-Remmlinger says that in managing his fund he focuses on fundamental research. “We analyse factors such as budget and trade balances and the credit quality of each country. This is done using our global research capability, including for developed as well as emerging markets. Risk assessment “The intention is to construct an overall risk assessment for each country. Part of this process is to evaluate the consequences of worst-case scenarios. These may include what happens if consumer spending declines, the flexibility of economies and the implications of rises in interest rates. We analyse the flexibility of tax systems in each country, will there be budget problems if GDP slows and can the government increase its tax collection. “We also evaluate the political situation. For example, when looking at Turkey, we would consider the likelihood and implications of the country joining the European Union. In Latin America, we would analyse recent political events in Venezuela. The ultimate question is which countries could have problems in financing their debt and may default on their repayments. In 2002-2003, Venezuela suffered a price default as its debt fell in value by 30 to 40 per cent.” The fund is predominantly invested in hard currency debt, notably dollar and euro bonds. “We would normally only invest up to 5 per cent of the portfolio in local currency debt. At the moment we have around 0.25 per cent to 0.5 per cent in local currency bonds,” says Mr Discher-Remmlinger. This has led to the fund outperforming the JPMorgan EMBI Global Diversified index over one, three and five years. Of the 10 largest emerging market bond funds domiciled in Luxembourg and Dublin, three are focused on emerging Europe. Indeed, the largest fund is the Deka-ConvergenceRenten fund. Wolfgang Zecha, manager of the fund, says that when it was set up in 2001 it was decided the fund’s lifespan would be too short if it was based on political convergence.

‘We do not expect emerging Europe to deliver the same double-digit returns as those of the past five years’ - Wolfgang Zecha, Deka

“If we focused on countries going through political convergence then the fund would only last a few years. Thus we invest in countries that are converging with the EU economically and those countries on the periphery of Europe that profit from close economic links. This includes Russia and goes down to North Africa. It is not just emerging Europe that supplies the EU. French and Italian companies, for example, have their supplies in Tunisia.” The fund, which invests in sovereign, quasi sovereign and corporate debt in a strategic allocation of two-thirds in local currency debt and a third in euro or currency-hedged US dollar denominated bonds, has three researchers and two economists. Mr Zecha says the research team frequently travels to the countries within the fund’s universe to meet, among others, finance ministers and central banks. The long-term country allocation is also determined by fundamental economic analysis, such as GDP growth and budget surpluses. “We have also developed a country risk model. We use fundamental research to try to pre-empt changes by the rating agencies.” Mr Zecha says he made the portfolio more defensive at the start of the year. This was done by reducing the fund’s exposure to hard currency debt and cutting the duration of debt. “Dollar denominated debt was reduced from 17 to 10 per cent within the portfolio to increase the cash quota. We also reduced some over-weight positions in the local markets, such as in the Polish zloty, which we felt was too aggressive, and increased under-weight positions in the Hungarian forint.” Sideways returns He believes the market correction may last another couple of months. “We do not expect emerging Europe to deliver the same double-digit returns as those of the past five years. There will probably be sideways returns over the short term. But it will still outperform other fixed income asset classes in the medium term due to the continuing economic division of labour and the political convergence anchor.” Over some time periods, emerging Europe underperforms global emerging bond markets. Mr Zecha says this is because emerging Europe is generally further along the road to convergence and yields are closer to those in developed markets. “This means there are lower potential upside returns from emerging Europe. But when there is a downturn in markets, emerging Europe is more defensive than global emerging bond markets.” Roman Swaton, manager of the DWS Europe Convergence Bonds fund, says his investment universe includes the countries that joined the EU on 1 May 2004 as well as Russia, Ukraine, Turkey and the Balkan countries. He can also invest up to 10 per cent of the portfolio in non-European debt. Mr Swaton currently holds 3 to 4 per cent of the portfolio in Kazakhstan banks, for example. The aim of the DWS fund is to take advantage of the investment opportunities presented by the convergence of the economies of emerging European countries with those in the EU and euro.

‘We think some of the more interesting stories are among corporates in Europe’ - Raphael Marechal, Fortis

“Emerging Europe has been compelling as there have been double digit returns in the bond markets since the late-1990s,” says Mr Swaton. “Central banks have inflation targets of around 2.5 to 3 per cent. The region has also been attracting foreign direct investments, notably from the EU.” Mr Swaton argues there is still more to come from these countries in terms of the convergence story. Only in the Czech Republic is the bond yield lower than in the eurozone. The key interest rate in the Czech Republic is 2 per cent compared to 2.75 per cent in the eurozone. Other emerging Europe countries, however, offer a yield pick up. He says 10-year rates in Poland are 5.60 per cent while they are 7.50 per cent in Hungary and 5.50 per cent in Slovakia. In comparison, 10-year rates in Germany are 4.04 per cent. “The yield differential can be even higher for short-term rates.” The income per head of population in most countries in emerging Europe is around 50 per cent to 60 per cent of the average of the eurozone countries. Mr Swaton adds that there are rapid growth rates in emerging Europe and currencies are likely to appreciate. He says the fund is 65 per cent invested in local currency debt and 35 per cent in euro or dollar denominated debt. The dollar denominated debt is hedged back into euros. “Local currency debt has not always been available in all emerging European countries and indeed is still not issued everywhere. The liquid local currency debt markets are Poland, the Czech Republic and Hungary and, to a lesser extent, Slovakia. There are only three liquid fixed coupon bonds in Turkey and there is little available elsewhere. “Until 1 July 2006, local currency debt in Russia was difficult to access for non-resident investors. You had to hand over up to 20 per cent of the investment in a non-interest bearing reserve account for up to one a year and when you sold the debt it had to sit in an account for up to 60 days. Another problem with access notes issued by special purpose vehicles (SPVs) was that we could only invest up to 10 per cent of the aggregate face value of that same issuer’s outstanding securities.” Mr Swaton likes banks in Kazakhstan. He says three banks each have a 20 per cent market share. “The banking regulation in Kazakhstan is better than in Russia and Ukraine so we are comfortable about investing there.” He says the sell off in May and June was driven by global concerns, particularly monetary tightening in Japan, Europe and the US together for the first time in 15 years. “We expect yields to fall in the region again, which will lead to capital gains from bonds. We also believe there will be currency appreciation in the region.” Raphael Marechal, manager of Fortis Bond Europe Emerging, says the fund was hit by the devaluation of the Turkish lira during the market correction of May and June. “We thought the Turkish lira would devalue by 5 per cent to 10 per cent against the euro but we did not expect a 20 per cent to 25 per cent fall. “Around 6 per cent to 7 per cent of the portfolio was invested in Turkey, but it has been offset by gains elsewhere in the fund. The Russian and Kazakhstan currencies performed well during the correction. This is because the fundamentals are attractive in these two countries. They have current account and budget surpluses, which is the opposite of the situation in Turkey.” Mr Marechal says the devaluation of the Turkish lira has been partly a result of investors deciding they are not happy continuing to fund a big current account deficit. He says the fund has been reducing its exposure to Turkey and is aiming for a portfolio allocation to 1 per cent or 2 per cent. “The sell-off surprised us and we are not sure how long the correction will last. It may be temporary, it could last a few months or a year.” The fund invests in sovereign and corporate debt in both hard and local currencies. Mr Marechal says two countries where it does not hold local currency debt is Turkey and Hungary. “Between 20 and 30 per cent of the portfolio is invested in corporate debt,” says Mr Marechal. “We think some of the more interesting stories are among corporates in Europe. Russian sovereign debt, for example, only offers spreads of around 100 basis points.” Another area where Mr Marechal says he has invested is in what he calls the second wave of convergence countries to join the EU. These include Serbia, Bosnia and Moldova. They offer more attractive spreads, says Mr Marechal, which are an average of 250 to 300 basis points.