Contagion becomes a distant memory

Emerging market debt has enjoyed a bull market for the past decade. While most other asset classes suffered from the bursting of the technology bubble, emerging market debt continued to deliver positive returns.

Over the past one, three and five years, for example, the JP Morgan EMBI Global Diversified index has returned +4.66 per cent, +38.85 per cent and +86.48 per cent respectively. However, fund managers say this asset class is difficult to measure against benchmarks. Chris Wyke, product specialist of emerging market debt at Schroders, argues that all indices are unrepresentative of the asset class as a whole.

“The weakness of the EMBI+ index, for example, is that it comprises dollar government bonds. But this only represents 14 per cent of the emerging market debt universe,” says Mr Wyke. “This means funds that only invest in this index miss out on 86 per cent of opportunities. The dollar government bond market is also getting smaller as a percentage of the total universe and less liquid as there is more issuance in local currencies and corporate bonds.

“Dollar debt in emerging markets comprises $450m against a total universe of $3000bn (E2400bn). Investors are taking a single currency bet with dollar denominated government bonds and 70 per cent of the EMBI+ index comprises just four countries – Mexico, Brazil, Russia and Turkey.”

Given this view, it is perhaps not surprising that Schroders takes an absolute return approach to managing its ISF Emerging Market Debt fund. The fund has delivered a positive return for 21 consecutive months, but this does not mean it is consistently a top performer, says Mr Wyke.

In the year to 1 July 2004, the fund made just 0.23 per cent against 4.66 per cent by the JP Morgan EMBI Global Diversified index. Mr Wyke attributes this underperformance to the cautious stance taken by the fund as he believed dollar bonds were over-priced.

Technical factors

Jerome Booth, head of research at Ashmore, has retained a bullish view and suggests the asset class will enjoy another 20 per cent return this year. “There are very strong technical factors at the moment. For example, the recent $6bn issuance of Russian debt in Germany was five times over-subscribed. This is a long-term growth story as there will continue to be large inflows into emerging market debt from pension funds, particularly from the US and parts of Europe. Pension funds should be looking to invest at least 5 per cent in emerging market debt so there is a long way to go. Funds such as Calpers have not made any allocation yet.”

Mr Booth believes the asset class has matured to such an extent that contagion is a thing of the past. Contagion, he argues, was a sign of irrational behaviour whereas the market is now enjoying rational reactions. “Why should a problem in Brazil affect debt in Malaysia?” Another reason for this optimism is the reduced reliance of emerging markets on borrowing capital. The number of countries that could not cope without foreign finance has fallen from more than 70 to less than 15.

Less risky

The rating agencies certainly suggest the economic strength of emerging markets has improved significantly. Greg Saichin, manager of the Pioneer Emerging Markets Bond fund, says: “Overall, the asset class has become less risky. Emerging markets have benefited from the rise in commodity prices, which have improved the balance sheets of companies and economic fundamentals. There has been a fundamental shift in many of the countries as voters will not accept policies that lead to higher inflation and budget deficits.

“A number of emerging markets have been tightening their financial belts. Brazil, for example, has introduced a social security reform programme and reduced very generous benefits to state employees among other measures in an attempt to cut its budget deficit. Other countries have been cleaning up their state finances as well.”

Mr Saichin says 42 per cent of countries in this asset class are now classified as investment grade (BBB– and above). This would have been 50 per cent if South Korea had not been taken out of the index. Along with this improvement in economic fundamentals, however, has come a narrowing of yield spreads against US treasuries. Mr Saichin says the spread between US treasuries and the EMBI Global Diversified index, for example, is just under 5 per cent and he stresses the need to focus on individual countries for investment opportunities. He cites the fact that the spread between Ecuador and US treasuries is 9.25 per cent, 6.3 per cent for Venezuela, 6.8 per cent for Uruguay and 6 per cent for Nigeria.

Pioneer’s performance was hit by redemptions in the second quarter of 2004 when liquidity was tight, says Mr Saichin. Three year performance, however, has been spectacular and well ahead of the index.

Uwe Schillhorn, manager of the UBS Emerging Economies Fund-Global Bond fund, cautions that investors should expect lower returns than the 15 to 20 per cent a year in the past, although there will also be lower volatility in the future. He expects spreads to trend sideways at between 4 and 5 per cent.

Mr Schillhorn adds that investors may take some money out of emerging market debt as interest rates rise in the US. If rates rise faster than expected, he says this could turn into substantial redemptions as investors turn away from riskier asset classes. However, he believes that much of the leveraged money has already come out of emerging markets. This is where investors have borrowed money in US dollars to invest in emerging market debt to capitalise on the higher yield.

This improved environment makes managers like UBS believe surprise defaults are less likely in the future. “But this must not be discounted, as surprises always happen and there are new countries coming into the investable universe,” adds Mr Schillhorn. After all, there have been 20 credit crises in emerging markets since 1994. Another cautious view is presented by Michael Mabbutt, manager of the Thames River High Income fund. Over one year, Thames River returned 18.01 per cent against 4.55 per cent by the index while over three years it has returned 127.72 per cent compared to 38.85 per cent by the index. His caution comes from the narrower spreads and that “too much good news has been discounted in the prices”.

Mr Mabbutt takes an absolute return approach and has held a cash position of up to 50 per cent in the past. At the moment, about 20 per cent of the fund is in cash.

The only emerging market debt fund to which Robert Burdett, co-manager of the multi-manager service at Credit Suisse, allocates money is Thames River High Income. Mr Burdett says he likes the fund because of the flexible approach of Mr Mabbutt and his team. “They might increase their exposure to cash to 60 per cent because of market conditions and then might buy government bonds in Brazil for 10 days because of price falls. This approach helps the team to manage the risk and volatility.”

Mohamed El Erian, manager of the Pimco Emerging Markets fund, argues that it is difficult to generalise about returns across emerging market debt. Pimco uses three “characteristic baskets” for emerging market countries: (i) anchor credits, with relatively low volatility, e.g. Mexico and South Africa.; (ii) return engines – more volatile but higher yielding countries, e.g. Brazil, Ukraine and Peru; (iii) intensive care countries seemingly offering high returns. “With these countries, there is a risk of further capital depreciation. For example, an investor might think he will get 27 cents in the dollar for Argentine debt,” says Mr El Erian. “But the debt might be restructured and the investor may only get 20 cents in the dollar, which is an immediate 25 per cent depreciation. As a result we do not own Venezuelan debt.”

Raphael Kassin, manager of the ABN Amro GI Emerging Markets Bond fund, takes a more aggressive approach. Indeed, 33 per cent of the fund is currently invested in Venezuela where El Erian is not invested. At the start of 2003, Mr Kassin held 30 per cent of the fund in Ecuador, which came down to zero by the end of last year and delivered a return of 53 per cent. This approach appears to work even though potentially it adds greater risk to the fund.

‘Cautious stance reflects over-priced dollar bonds’
Chris Wyke, Schroders