Developing country debt vehicles entice private investors

Investors have been pouring into emerging market funds to obtain exposure to the superior growth prospects of less developed markets.

While emerging market (EM) stock funds were the hot story last year, EM bond funds are now the big attraction, and are seen as a less volatile home than equities but offering the attractive yields and rapid growth missing in the developed world. Year to date, through to September 1, EM bond funds have taken in $34bn (€26.7bn) of net inflows according to data from EPFR Global. The previous record inflow for an entire year was in 2005, when they took in $9.7bn.

Investors have also taken comfort from the more disciplined management of government finances and monetary policies focused on inflation targets, which have helped reduce the volatility of bond market returns across Asia.

Sound fundamentals

The exponential growth in the take up of EM bonds is largely institutional investors such as pension funds diversifying into the asset class for the first time, which can mean single allocations of as much as $100m. Fund managers report they are taking a lot of reverse enquiries.

At Pictet, for example, EM fixed interest under management has trebled to $14.4bn, from $4.5bn-$5bn last December.

“Emerging markets have provided substantial opportunities over the past decade in terms of returns on the back of steady improvements in fundamentals,” says Matt Ryan, vice president of MFS Investment Management. “Flows into emerging market fixed income have been steady and large as investors navigate between equities, which are still perceived as too risky, and risk-free rates, which offer negligible returns,” he explains.

“In general, credit markets – including emerging market debt – have offered a middle ground in a global economy that is muddling along. When investors examine the risk-adjusted returns of the asset class and the solid fundamentals underpinning its multi-year outperformance, one can increasingly look at emerging market debt as an alpha story rather than beta story – one that can outperform in both bull and bear markets,” adds Mr Ryan.

Each country presents a completely different set of risks, however, even among the more developed nations such as South Korea, Malaysia and Brazil, where mutual funds concentrate their efforts. Fund managers generally avoid less stable regions such as Venezuela, Ecuador or Iraq. Currently, emerging Europe has joined those out of favour as GDP growth is weak and debt positions are causing concern.

One approach is to choose growing economies, but ones where central banks will not raise rates by as much as the market predicts.

“Our general strategy is to look for a solid and stable credit and markets where there is a belief that the recovery is robust and that central banks will have to follow a tightening policy, but where we think that is wrong, where we actually think the central bank won’t have to tighten as much as the market expects because the global recovery is more tepid than the market thinks,” says Michael Gomez, executive vice president at Pimco.

“In Latin America, we think Brazil is a unique and attractive story. It has experienced sharp growth and so some investors fear a higher core inflation rate and the market has interpreted a larger tightening cycle, but in reality the recovery is more tepid and deflation forces are in evidence in the developed world,” he says.

Mr Gomez explains that while nominal rates for Brazilian bonds are around 11.5 per cent, real rates are some of the highest in the world. “This is probably a result of Brazil’s history of inflationary shocks, so the local population is quite guarded and demands a significant premium,” he explains.

“The consumer price index is currently 4.6 per cent against the Central Bank’s mandate to keep it at 4.5+/- 1.5 per cent, and the Central Bank has a reputation as credible and hawkish. Mexico is a similar story.”

Searching for alpha

So large are the inflows into this asset class that they have even begun to constrain opportunities for managers to outperform, according to MFS’ Mr Ryan. “Managers are really branching out and looking to add alpha with local currency and corporate bonds and we are seeing a lot more issuance in those areas to accommodate that need for more attractive risk reward opportunities,” he says.

Most EM bonds were traditionally sovereign, but corporate bond issuance is growing as businesses look for new sources of funding and as foreign investors become more comfortable with improvements in corporate governance, transparency and local legal systems.

Low nominal rates and favourable inflation trends have also allowed the corporate market to spring to life. In Turkey for example, double digit nominal rates were prohibitive for years but rates are now down to 8 per cent.

Incremental gains can also be achieved by buying local currency bonds, which offer the opportunity for currency appreciation. Historically, most government issues were denominated in hard currencies such as the dollar, but governments have been keen to take control of their debt. China’s new policy of allowing a gradual appreciation of the renminbi is seen as a potential driver for currency appreciation across emerging Asia.

Local currency bonds also offer greater opportunities for exploiting discrepancies in the market than their hard currency equivalents, because many investors are still not set up to trade them. The investable EM local debt market is over $700bn, with less than 20 per cent owned by foreigners.

As local currency bond returns comprise both bond yields and the underlying currency, it is important to always ask two questions, says Alexander Kozhemiakin, director of Emerging Market Strategies at Standish, part of BNY Mellon Asset Management. “Is there value in the currency and is there value in the local bond yields? If we only like the currency, we exploit it using short duration currency forwards. The advantage of our fund relative to pure currency funds is that we avail ourselves of opportunities in local duration as well. Where available, we can also invest in inflation-linked debt.”

Mr Kozhemiakin reckons that the total return from local currency bonds is 2/3 attributable to currency (changes in spot rate plus carry) and 1/3 from local duration (excess returns of bonds relative to cash). Historically alpha has been generated half and half, but in some time periods the balance varies widely, for instance 80 per cent of alpha return was derived from currency last year and 80 per cent from bond duration this year. Looking ahead Mr Kozhemiakin believes currency will generate 60 per cent of alpha, while duration bets will contribute the remaining 40 per cent.

Local currency bond funds are generally focused on the most liquid markets, and managers say this provides the flexibility to profit from the best opportunities. “You can take advantage of trends at different times in the cycle, increasing duration when there is slower growth by extending further along the interest rate curve for example,” says David Dowsett, senior portfolio manager at BlueBay.

“Local markets are slightly different to credit which moves together one way and then another. With different instruments we can create value at different points in the cycle.”

There are three main risks to the sector, however, according to Simon Lue-Fong, head of Emerging Debt at Pictet. The first is broad dollar strength which could damage exports of commodities; rising wheat prices and food inflation because EM inflation baskets are heavily weighted to food prices; and deleveraging – if investors start to withdraw from risk assets, a run on these assets could follow.

The 2008-9 period also brought out the worst in some corporate bond issuers. “Some companies took advantage of adverse market conditions and reneged on their deals regardless of their financial position,” says Yerlan Syzdykov, manager of the Pioneer Emerging Markets Bond Fund.

“Bondholders fighting for their rights have found it can be difficult to press against these companies. Those with bonds issued in jurisdictions such as the British Virgin Islands and Cyprus are experiencing difficulty in recouping their cash, so now there are speciality teams in the market that follow corporate bonds carefully.”

Nevertheless, there are good opportunities that will repeat themselves says Mr Syzdykov.

“Securitisation has been a dirty word, but there are opportunities such as the Ukranian government’s securitisation of its debt liabilities for VAT refunds to exporters. The new VAT bonds’ pricing is yet to be finalised but is expected at mid- to high- single digits, offering an interesting entry point into local market. Securitisation and asset-backing is reviving itself in emerging markets quicker than anywhere else.”

Rising levels of wealth will favour local currencies

“We have a positive view on emerging market debt,” says Robin Perry, Director at Deutsche Bank Private Wealth Management. “First, emerging market fundamentals remain strong as evidenced by long-run trends in credit upgrades and in areas such as industrial production and retail sales. Second, structural demand for the asset class looks set to increase steadily from institutional investors.”

This positive view also extends to emerging market currencies. “In the medium-term we expect EM countries to raise interest rates and let their currencies appreciate to restrain inflation,” he explains. “On a long-term view, currencies tend to appreciate as countries grow richer and rising wealth in the developing world is likely to be a major global trend over the next decade. For this reason we favour local currency over dollar-denominated bonds.”

One issue is that foreigners can purchase local bonds in only 14 countries, says Sam Finkelstein, MD, Global Fixed Income, at Goldman Sachs Asset Management. “Most clients therefore want holdings in the largest countries to be limited. The Brazilian market is many times bigger than others, accounting for perhaps 20 per cent of the index and investors typically look for that to be constrained.”

Managers report an appetite for regional funds, and for corporate-only mandates.

Holding EM debt within a portfolio results in an attractively low level of correlation with other asset classes, and correlations between EM regions such as Asia and Latin America are also low. “Dedicated EM bond funds offer a broad diversification at low cost,” says Nicolas de Skowronski, head of Investment Advisory at Bank Julius Baer in Zurich. “But although EM bond markets have made big progress in terms of market opening, breath and liquidity, there are still some regions for which specialised local currency bond funds offer the best access.”

“We pursue an active stance with selective single bond holdings in the ‘nearly developed’ markets such as Brazil, Mexico, or Central Europe, and bond funds for smaller markets and themes,” he explains.

“At this juncture, we look especially at absolute return bond funds because interest rates in mature markets are close to their bottom, currency volatility remains elevated, and the outlook for monetary policy in Western markets is uncertain,” says Mr de Skowronski. “Of course, if all goes well like last year, absolute return bond funds might underperform slightly versus long-only funds, but clients are compensated by higher stability.”

In Asia and Central Europe, he prefers local currency bonds to benefit from the currency revaluation. “In some specific markets such as Brazil, the currency looks rich, and we focus more on hard-currency debt of promising local issuers,” adds Mr de Skowronski.

Deutsche Bank PWM’s recommended fund for this asset class is the Pictet Emerging Local Currency Debt fund, adds Deutsche’s Mr Perry. “Pictet has a well resourced EM Debt team headed by Simon Lue-Fong who has 20 years experience in the sector. Their investment process has produced above average returns while controlling risk and the fund has been less volatile than the benchmark since inception.”