Emerging market debt shows no sign of a let-up

Emerging market debt (EMD) was the world’s best performing asset class last year and ongoing hunger for yield and investors’ desire to diversify their fixed income allocations away from developed markets creates a compelling outlook for 2013 as well.

With global banks committed to keeping interest rates low, increased demand for higher yielding assets has pushed record levels of capital into EM debt, driving sovereign and corporate yields toward historic lows.

Fund inflows into local and external debt strategies reached a new record of $94bn (€70.5bn) in 2012. Flows into dollar-denominated debt more than doubled their previous annual high, according to JP Morgan research.

The asset class is supported by stronger balance sheet and growth prospects. The gap between developed and emerging market sovereign ratings has considerably narrowed, and the convergence and ratings upgrade trends is expected to continue in 2013. “Due to their strong balance sheets and net external credit status, EM sovereigns are now seen as a flight-to-quality trade,” explains Pierre-Yves Bareau, head of emerging markets debt at JP Morgan Asset Management. “We believe that 2013 will see this convergence story continue, as EM countries continue to be rerated higher and as negative ratings pressure continues in developed markets.”

Although double digit returns are unlikely to be repeated, hard currency EMD is still benefiting from more demand, or inflows, than supply, or issuance and is likely to generate “solid returns”, states Mr Bareau. Spreads still offer value compared to developed markets, although EMD yields are at record lows. At the same time, emerging markets continue to enjoy strong balance sheets and more flexibility to adjust monetary and fiscal policy, he explains.

After an exceptionally strong 2012, with the JP Morgan CEMBI Broad Index returning more than 15 per cent, JP Morgan expects EM corporate bonds to return in the region of 7 per cent, with valuations remaining attractive in a global low yield environment, especially when compared to US corporates. In 2012, EM corporate bonds reached a milestone as supply exceeded $300bn and the debt stock exceeded $1tn, close to the size of the US high yield market, according to JP Morgan. “EM corporate bonds have come of age with increased sponsorship from a diversified investor base,” says Mr Bareau.

Room for compression

A backing up in US Treasury rates is one of the key risks for hard currency products, but there is room for spread compression for both EM external debt and the corporate debt.

“The fundamentals of both EM sovereigns and corporates are better than the spread is currently reflecting, so we think they should trade at a tighter level,” says Rob Stewart, client portfolio manager in the EMD team at JP Morgan Asset Management.

The developed markets debt to GDP ratio is more than 100 per cent, according to the IMF, while it is close to 36 per cent on average for EM countries. On average, the fiscal deficit for developed markets is 6.5 per cent but is just below 2 per cent  in emerging markets.

Local currency EMD, which is less sensitive to US treasury rates moves, is expected to be the best performing asset in EMD this year, as the macro-economic backdrop represents a “sweet spot” for this asset class, according to JP Morgan. EM currency has lagged other risk assets last year but it should benefit from a recovery in growth and continued central bank liquidity. Particularly those currencies with higher interest rates and a link to economic cyclicality are expected to do well.

“EM local currency sovereign is our favourite play for this year. We think this sector will outperform the hard currency sectors. Currencies will do well in an environment where the growth in EM has bottomed last year and is starting to turn upwards,” says Mr Stewart. Although inflation may become more of an issue in the second half of the year, is it not seen as a threat today, he says, which is allowing central banks to maintain the stimulative policy, with Colombia and Hungary recently cutting rates to stimulate their respective economies.

In addition to currency appreciation, a more dynamic management of portfolios will drive returns. “Last year a long duration trade was one of the key drivers of return both in the hard currency and local currency markets. This year asset managers have to be more nimble and dynamic in how we allocate to duration and how we rotate risk from one sector to another,” says Mr Stewart.

EM corporate debt, which is largely in hard currency, is Pictet’s favourite asset class in the fixed income space.

“Sovereign hard currency debt has had a tremendous run over the last couple of years and the spread on the JP Morgan Emerging Market Bond Index (EMBI) is quite low with at around 260  basis points coming all the way from 900 basis points after the Lehman debacle,” says Mussie Kidane, head of fund selection at Pictet & Cie. The tightest spread was reached in 2007. With a yield of 4.6 per cent and average duration of 7.3 years, this segment looks expensive and also faces the risk of rising US  interest rates, he says.

EM corporates are much more attractive in terms of their growth dynamics and valuation, or spread, in the sector.

“Given the growth prospects for emerging markets and how less levered EM corporates are to their developed markets equivalents, we think EM corporate debt is a better opportunity set than US high yield or EM sovereign debt,” says Mr Kidane.

On the sub-investment grade or high yield space, the case is much more compelling, he says. “A high yield rated company in EM today yields more than a French or German company with the same rating although it is less levered. So on average you have companies in EM with better balance sheets, operating in regions with growth, whose debt has a shorter duration and yields more. We think it is is a better place to be, although we admit that EM credits are less liquid and a proportion of that spread advantage is just the liquidity premium.”

In addition to the in-house asset management house, Pictet sources two actively managed funds from two major asset managers in the EM corporate debt space for its clients’ discretionary mandates.

The selected managers have the flexibility to invest where value is, be it investment grade or high yield. The neutral point is the EM corporate index weight, which is around 75 per cent investment grade and 25 per cent high yield with a year to maturity of 4.5 per cent and a duration of 5.3 years. One of the managers that Pictet works with has invested 75 per cent of its fund in high yield and 25 per cent in investment grade, with a portfolio yielding close to 9 per cent and  duration of four years. A global portfolio rather than one focused on any specific region is preferred, he says.

Local currency corporate debt remains very small, despite huge growth potential. The renminbi-denominated bond, or dim sum bond market, for example, has been expanding significantly.

“The dim sum bond market is in its early stage. It may become  a huge market one day, but today it is not attractive from an investment stand point: it is relatively small, less liquid and concentrated,” says Mr Kidane, struggling to understand how active managers can manage a fund in this space.

“There are only a few companies to choose from and the yield is very low, because they mimic the RMB interest rate. An RMB denominated fund is just a marketing gimmick, as it stands today.”

At Pictet, EM corporate bonds are preferred to EM currencies and local currency government bonds. “Clients’ portfolios already have a very volatile currency-linked exposure to EM via equities, so we look at this asset class from a portfolio construction standpoint,” says Mr Kidane.

Manpreet Singh Gill, senior investment strategist at Standard Chartered, brings the perspective of an Asian-based bank. The investment bias is understandably in favour of the Asian region, although the focus is also increasingly on the Middle East, in the form of GCC bonds, he says.

“Asia local currency government bonds is one of our top conviction ideas,” says Mr Gill, addressing the presence of value in this asset class, with positive real interest rates and rising currencies the key pillars. Venturing into corporate bonds in local markets is a risk that is not worth taking, but clients need to keep their return expectations realistic, as spreads have tightened so much in the fixed income space, he says. The yield is likely to provide the bulk of returns over 2013 as significant further capital gains are unlikely.

The Indian local government bond market is currently the most attractive, he says, where yields are higher than anywhere else in Asia, with 8 per cent on a 10 year government bond. Also, a likely cut of Indian interest rates will drive up the prices of bonds and the Indian rupee is expected to appreciate.

Most Asian countries have pretty well developed government bonds markets. Some of them have been issuing bonds in US dollar for a long period of time, such as India, Indonesia, Philippines and Malaysia, but there are also many countries which are coming to the US dollar bond market for the first time, such as Vietnam and Sri Lanka, where bonds are not as liquid and investors cannot find the duration they seek.

Selectivity will be key in emerging markets investment grade and high yield, notes Mr Gill. While he sees greater value in investment grade, he holds a neutral view on Asian high yield. “We do not believe today’s record low yields and increasingly tight spreads compensate for rising risks,” he says, explaining US high yield instead continues to look attractive.

In Asia the two risks over and above high yield investing elsewhere are liquidity, as the markets are not as liquid and deep as US high yield. In a risk off scenario liquidity would dry up very quickly and investors may not always be able to find a buyer for their bonds, regardless of the price. Another issue is concentration risk. “Unlike US high yield, Asia high yield does have a lot of sector and country concentration. For example, about one third of the regional high yield benchmark consists of Chinese high yield mainly.”

Currency wars

EM local currency government bonds will outperform their hard currency equivalents this year, with EM currencies looking comparatively cheap and providing a good source of alpha, says Anthony Simond, EMD analyst at Aberdeen Asset Management. In fact, the majority of inflows in January have been going into local currency debt stategies. This is different from last year, where blended and hard currency took most of the money. But the risk primarily comes from the currency part.

Japan’s recent announcement of quantitative easing had a pretty bad effect on Asian currencies as a result. Rhetoric about a resumption of local currency wars, where central banks would look to intervene in their currency to keep it competitive, is also worrying, he says.

 “EM central banks today control some 80 per cent of world foreign exchange reserves, which places emerging markets at the core, not the periphery, of global
currency issues,” says Jan Dehn, co-head of research at Ashmore Investment Management.

“Heavily Indebted Developed Countries (HIDCs) will eventually deleverage by means of currency weakness and inflation,” states Mr Dehn. “The only way to hedge against the approaching global currency realignment is to steadily and continuously diversify out of HIDC bonds and currencies into EM local currency instruments.”

Unlike in GEM equity, where MSCI makes an official distinction, there is no true definition of a frontier market when it comes to EMD, but these are generally classified as smaller, under-researched countries which are less than 2 per cent of the JP Morgan index, according to Aberdeen. So-called frontier markets are responsible for a “significant proportion” of the Aberdeen flagship fund’s outperformance.

Robert Abad, EM portfolio manager at Legg Mason’s subsidiary Western Asset, highlights the growing high yield EM sector which includes corporate borrowers as well as lower-rated sovereigns such as Argentina, Ukraine and Venezuela, and frontier markets including Sri Lanka, Mongolia and Belize.

On the sovereign side, EM high yield offers an opportunity to play the improvement story from the beginning, with significant capital gains available as frontier markets move up to emerging status, says Mr Abad.

From a corporate perspective, investors can get higher yields and significant spread pick-up via higher-quality EM high-yield corporates versus lower-rated US equivalents.  “The higher yields and shorter duration of EM high-yield credit also offers a considerable buffer against any rise in US interest rates should macro conditions stabilise earlier than anticipated or quantitative easing/growth-induced inflationary fears materialise,” says Mr Abad, urging however investors to remain disciplined and not fall into the trap of assuming EM high yield functions like a faster-growth version of the more mature US market.

“Without restraint, investors risk chasing yield into a reversal in global liquidity.”