Taming the new funds frontier

Emerging market debt has come a long way over the past few years. Before the millennium, a crisis in one country would spread rapidly to all the others. The asset class is still not immune to external events, however, as was demonstrated by investors taking fright after the expected and actual downgrading of the debt of General Motors (GM) and Ford.

Such was the risk averse reaction by investors after the announced intention by Standard & Poor’s in March to downgrade GM and Ford that spreads widened significantly.

Fund managers in this asset class, however, argue that the virtually complete bounce back shows the strength of fundamentals in emerging markets and the improvement in credit quality over the past few years.

	“Developing countries possess large pools of factors of production such as land and labour that are lying idle because of a lack of access to reasonably priced capital” - Jerome Booth, Ashmore IM
	“Latin America has moved to a positive fiscal balance for the first time in many years. The improvement in its debt looks sustainable” - Michael Hasenstab, Templeton

On 8 March, spreads between the EMBI Global index and US Treasuries were 340 basis points. They widened to 412 basis points after S&P said it would downgrade GM and Ford but spreads have subsequently come back to 300 basis points. The spreads cannot be compared like for like, however, because Argentina has since issued new hard currency bonds in place of defaulted dollar denominated bonds. Rob Drijkoningen, manager of the ING’s emerging markets debt fund, says on the old basis, spreads are now equivalent to 365 basis points.

Mr Drijkoningen admits emerging market debt spreads over US Treasuries are at historically tight margins but he points out that so are corporate bond spreads in developed markets. He adds that economies are growing across emerging markets and, therefore, improved credit quality justifies tighter spreads and the lower risk that investors now take with emerging markets debt. Mr Drijkoningen says credit quality in emerging markets has been improving for the past 12 years since the JPMorgan index range was established.

High price of commodities

Another factor that has helped emerging markets has been the high price of commodities, especially oil. “A number of emerging market countries have benefited from the high oil price, such as Venezuela and Russia,” says Mr Drijkoningen. “The increased oil revenues have improved governments’ balance of payments and therefore credit quality. We like Russian debt partly because of the oil dollars but also because of the reforms being implemented.

“We are also overweight in countries like Argentina, Brazil and Ukraine. We are generally overweight in riskier countries because we are happy with the fundamental economic factors in these countries,” he adds.

Mr Drijkoningen stresses that the situation does vary across emerging markets, however, and he will not invest in certain countries because of the risk. He says his fund takes on average a more aggressive approach than others in the sector. As a result, it is the top performing fund in the sector, according to Standard & Poor’s, over the past five years and second over three years.

But, if Mr Drijkoningen is concerned about economic fundamentals, he will reduce exposure to the riskier markets. Of future risks, he highlights elections across Latin America next year as creating uncertainty.

Interestingly, the hard currency fund managed by Mr Drijkoningen has out-performed his local currency fund over one and three years. While the local currency fund has returned 14.31 per cent and 15.54 per cent over the past one and three years respectively, the hard currency fund has returned 22.72 per cent and 75.71 per cent. It is argued that local currency returns are more stable and less volatile than those delivered by hard currency debt in emerging markets.

Christopher Wyke, emerging markets debt product manager at Schroders, says spreads may appear to be tight but indices represent only a small part of the investable universe and therefore do not accurately reflect the investment opportunities across the whole asset class. This is because indices tend to only comprise hard currency denominated debt. This also means, say fund managers, it is unrealistic to compare fund performance with indices, including the JPMorgan EMBI index.

“Dollar denominated debt represented about 50 per cent of the market 10 years ago whereas now it is around 10 per cent of the $3,000bn (e2,480bn) tradable investment universe,” says Mr Wyke. “Yet, 70 per cent of the JPMorgan EMBI index is made up of just four countries – Brazil, Mexico, Russia and Turkey. Less than 10 per cent is in Asia.”

Record lows

With yields close to record lows in many emerging markets, Mr Wyke warns that in some cases it is hard to see how investors can make money from dollar denominated debt. There are risks in a number of markets. “If things go perfectly well then investors may make their coupon in some debt paper. But we would expect Ecuador to default in the next few months. The finance minister of Ecuador has even called for a default.

“Venezuela should be in a better position given all of its oil. Russia has improved its financial position but it now looks expensive.”

Mr Wyke, however, says there are also some opportunities in emerging market debt. “Argentina dollar bonds in default offer 36 US cents in the dollar. The country has to settle with people to re-enter the capital markets. Potentially, it could be possible to get a US court judgement to be paid $1.35 in the dollar. We like Eastern European bonds because of the convergence story with Western Europe. There are also special situations such as Indonesia or the Philippines and where we believe a currency will strengthen.”

According to Mr Wyke, the Schroder fund is more cautious than other funds in the sector. He says the fund outperforms when markets are not so strong. Over the past year, the fund is ranked 67th in the sector out of 73 with a return of 9.68 per cent whereas over five years it is 39th out of 49th with a return of 27.82 per cent.

Case by case basis

Michael Hasenstab, manager of the Templeton emerging market bond fund, says in the current market environment it is important to analyse each company and government debt on a case by case basis. He is an advocate of diversifying into local currency debt. “Local currency debt is tied to domestic interest rates and monetary policy rather than what is happening in the US. Local developments can offset rising US interest rates. Poland, for example, has been reducing interest rates while the Federal Reserve has been raising US rates.”

He says there is an argument for being cautious on some dollar denominated debt. “There is no doubt that fundamentals have improved generally. Latin America has moved to a positive fiscal balance for the first time in many years. The improvement in its debt looks sustainable. The reason interest rates are rising in the US is because of economic growth. The outlook for the global economy, therefore, looks positive and emerging markets will benefit as they are generally exporters.”

He adds: “But you must look at each country to see if it is still offering value as spreads have tightened. For some emerging market debt, we believe the good fundamentals are fully priced in. We are currently finding value selectively in Latin America, in local currency debt in Eastern Europe and some local markets in Asia.”

Mr Hasenstab says that as with all other Templeton funds, this vehicle looks for long-term value over at least a five-year view. “We do not get influenced by short-term price movements but seek fundamental value for the medium and long term. This may mean we miss out on some short-term gains that we consider are not based on fundamentals.” Over the past year, the Templeton fund has returned 18.06 per cent against a sector average of 18.05 per cent.

While most fund managers express at least some caution about valuations, Jerome Booth, head of research at Ashmore Investment Management, is bullish about the outlook for emerging market debt. This is partly based on a re-weighting of asset allocations by investors. It is also linked to Ashmore’s thesis that spreads are less relevant when analysing an asset class undergoing a transition. “Emerging debt is experiencing a strong structural change in its investor base as pension funds and other long-term institutional investors make strategic allocations for diversification as well as to try to increase returns.

“This structural change is likely to last at least five years and is driven in large part by unfunded liabilities and poor actual and expected performance in major asset classes.”

Fastest growth

He adds that even though demand is strong this will be met by a plentiful supply of debt. “Developing countries possess large pools of factors of production such as land and labour that are lying idle because of a lack of access to reasonably priced capital of less than 15 per cent interest rates. This means that demand from investors creates its own supply of paper. The emerging world represents 85 per cent of the global population and is expected to include the areas of fastest economic growth in the next few decades. There is no shortage of bond issuance on the horizon.”

He argues that the downgrade of GM and Ford to junk status serves to highlight the relative attractiveness of emerging market debt compared to US corporate debt. While the credit quality for emerging market bonds is improving, says Mr Booth, it is declining for US high yield.

“Emerging market debt is the only major credit market not fundamentally linked to the US business cycle,” says Mr Booth. “Although emerging market bonds and high yield rallied in 2004, they are now de-linking strongly. Index re-weighting favours inflows into emerging market debt from high grade. As GM and Ford leave high grade indices so emerging market investment grade sovereigns are entering them.

“Portfolio flows show outflows from high yield and inflows into emerging market debt following the GM and Ford downgrades.”

“We are generally overweight in riskier countries because we are happy with the fundamental economic factors in these countries” - Rob Drijkoningen, ING