Strong inflows into emerging market bonds reflect changing world order

Emerging market local currency bond funds attracted an average of $400m (€292m) a week through the summer, according to EPFR data, as investors sought income and safety, both of which are scarce in the current climate. Despite faltering in early September, strong inflows are expected to resume through the rest of the year in a reflection that the global balance of power is changing and the attractions of growth economies are set to be long-term and enduring.

Most interest is focused on local currencies because investors feel there is more upside potential in currency appreciation, and remain wary of the dollar and euro. Emerging market currencies are expected to appreciate about 3 to 5 per cent per annum for the next five years in something of a self-fulfilling prophesy as flows to emerging markets continue to grow.

In comparison with their Western peers, emerging market bonds offer the twin attractions of both stronger balance sheets and juicier yields. The JPMorgan GBI-EM Index is currently yielding 6.20 per cent compared with 0.8 per cent for five-year US Treasuries and 0.85 per cent for five-year German Bunds.

The yield outlook is encouraging because rates in many growth countries were raised in the first half of the year on central bank concern about inflation, but that may have been overdone and some are now at a point where they may start to reverse those decisions.

“Combining the two drivers, emerging market local currency bonds can be expected to show yearly total returns close to 10 per cent for the next five years, or even 13 per cent in our more bullish scenario,” says Ernesto Bettoni, investment specialist, emerging markets fixed income at BNP Paribas Investment Partners.

INFLATION FEARS

Mr Bettoni points out that inflation has been a major concern at times over the past three years, but in each instance the market turned out to have been overly-negative. In October 2008, and again in May 2010 and January to February 2010, most yield curves in emerging markets steepened because of expectations that central banks would raise rates drastically.

Each of the 40 growth markets is markedly different however. Not every country has experienced inflation and some central banks are more proactive than others.

It remains the case that inflation is more of a threat in Asia than Latin America, and there is still a perceived risk in some regions of insufficient tightening.

“It is important for local authorities to continue to normalise policy in economies where activity has returned to its long-term potential,” says Michael Hasenstab, portfolio manager at Franklin Templeton Investments.

“This can be a politically sensitive issue, but it is crucial in order to avoid overheating economies, inflationary pressures and asset price bubbles over the next several years,” he explains. “Economic outperformance, particularly in Asia ex-Japan, is attracting record levels of capital, which has been fuelled by very loose monetary policy in the developed world. Against this background, economic policy must remain forward looking, and policymakers must not become complacent due to temporarily contained price pressures.”

Within local currency debt, Latin America stands out as a favorite region, with Brazil and Mexico the flavour of the month.

“Brazil is showing a strong inflationary impulse at around 7 per cent, while its monetary policy rate is 12.5 per cent so Brazil could cut rates by 5 per cent and still have positive front end real rates,” says Michael Gomez, co-head of the emerging markets portfolio management team at Pimco.

“The central bank therefore has much more room to ease interest rates than the ECB (European Central Bank) as one example, which can cut by only 1.5 per cent.”

US DOWNGRADE

In a fundamental reversal from a decade ago, the biggest risk factors now stem from developed countries. US growth and employment figures have been disappointing, and the recent US downgrade by ratings agencies has exacerbated weakness in its equity markets and the dollar.

“The developed world has been told that there will be lower rates for longer,” says Simon Lue-Fong, head of Pictet’s emerging debt team, which has $19bn under management.

“The Fed has indicated that rates will be held near zero until mid-2013 so we know rates will be zero at the front end, forcing investors to look for yield,” he adds.

This is the first time the Federal Reserve has promised to peg its exceptionally low rates to a specific date, and it may be an indication of the level of difficulties ahead, particularly as Fed chairman Ben Bernanke previously expected the economy to rebound in the second half of the year.

“The best hope for the US is slow growth and the worst is a real depression,” says Jerome Booth, head of research at Ashmore.

“Emerging markets are therefore attractive not just for what we used to call ‘risk adjusted returns’, but fundamentally to reduce risk. Investors should be taking money out of the crash zone, but denial (that this is the situation) is a powerful behavioural characteristic,” he explains.

“Our main scenario, which we think is about 65 per cent likely, is several years of deleveraging and slow growth but no major catastrophe,” says Mr Booth.

“In this scenario, emerging market asset classes would outperform developed world equivalents. Other scenarios are a US depression or an EU sovereign or bank crisis, and emerging markets could be negatively impacted, but remain safer than the developed world.”

Mr Booth argues that the US suffers from a lack of political will to resolve the imbalances. It is, he says, as though there is a corpse on the kitchen floor. “In Europe, the policymakers know the dead body is there but they have put a sheet over it, while in the US the policymakers are in complete denial and have given it a cup of coffee and are trying to have a conversation with it.”

LIQUIDITY PRESSURE

There is still a lot of financial interconnection despite the foreign exchange reserves and many emerging market companies, as well as some sovereigns, still borrow in hard currency, so a degree of liquidity pressure will remain, says Guillermo Osses, head of emerging markets debt portfolio management at HSBC.

“However, 2008 was the first time in history that emerging markets had the resources to ease liquidity problems, and the first time in history that emerging markets currencies did not sell off sharply in a crisis was the second and third week of August this year, when the S&P lost 18 per cent,” he says.

For example, the Brazilian real, which had been sensitive in the past, only depreciated on 9 August to 1.66, and then appreciated to end the day at 1.59, very close to the highest it has been for the last 10 to 11 years, he explains.

“Since 2008, when market participants realised that central banks in emerging markets would use their reserves to help themselves, their inclination to sell those currencies when there are problems in the developed world has reduced substantially,” says Mr Osses.

“Rates are now more likely to go down in a crisis than up, a sign that these economies have matured and to some extent decoupled from Western economies.”

Corporate bond issuance and local investor demand have both grown strongly, indicating a maturity in the market.

“Corporate bond issuance has been growing as companies can finance themselves at much more attractive levels, and the banking crisis has restrained the ability of banks to lend,” says Claudia Calich, head of emerging markets at Invesco Fixed Income.

“There are the different countries and a wide range of qualities to consider, including more recently a handful of distressed names which gives quite a range of opportunities to choose from,” she adds.

“The recent crisis has ironically prompted a flight to dollar strength, but emerging markets are much more robust than previously,” explains Ms Calich.

“In the last crisis fund managers had to sell their emerging market holdings to meet redemptions, and so the sell-off was technically driven,” she adds. “This time around, this is where we need to watch carefully. It hasn’t happened yet, but no asset class would be immune to a deepening of the crisis in Europe.”

The changing risk profile of the asset class has been attracting a greater number of institutional investors. Around 80 per cent of emerging markets local bonds now investment grade, and eligible for low risk mandates. At BNP Paribas IP for example, around 50 per cent of new investors in the asset class are pension funds or central banks.

This is another virtuous cycle for the market, as it makes for a much more stable investor base compared with the preponderance of fickle short-term investors such as retail investors, proprietary traders or hedge funds a decade ago.

An interesting opportunity for diversification

Deutsche Bank Private Wealth Management has ramped up its allocations to emerging market debt in the last 12 months, hiking it from 2.5 per cent to 7.5 per cent in its multi-asset portfolios, and from 10 per cent to 15 per cent in its income portfolios.

“Ten years after the Asian crisis of 1998, growth economies have taken the opportunity to deleverage, and so clients are beginning to view this asset class as more important and interesting, as well as simply to diversify away from the balance sheet problems of the US, Europe and UK,” says Paul Wharton, UK chief investment strategist at Deutsche Bank Private Wealth Management.

“We generally try to use ETFs (exchange traded funds) such as iShares to diversify holdings, but in emerging markets it is more typical to use managers with good track records such as Pictet and Templeton, particularly as the opportunity sets have grown.”

Corporate debt in growth economies is increasingly used as the market is developing and there is a general awareness among clients that there are more opportunities, and that these nations account for some of the world’s largest economies and have mature companies, he explains. “Now may also prove the opportunity to be invested at the peak of the interest rate cycle,” adds Mr Wharton.

Johan Jooste, portfolio strategist at Merrill Lynch Wealth Management, also prefers active managers for this space but says clients are watching and waiting.

“At the moment, emerging market credit is a developing space and the market is in a state of weighing it all up and seeing how it pans out. Credit investments are not suited to volatile markets, so we have not seen money flooding into the asset class; it is more a case of investors sitting out the volatility in the rest of the world.

“Changes in perception are going to be incremental,” adds Mr Jooste. “The wealth management industry does not change its conventional wisdom very fast. Wealth managers tend to have offices based in London, New York, Tokyo and Geneva and so what happens, happens from a distance and there is not a great deal of local knowledge. This itself is an issue that is being addressed slowly but surely.”

He warns however that there can be no guarantee that it will all be plain sailing from now on, and that crises such as that of 1998 and 2001 in Argentina will not happen again.

David Absolon, an investment director at Heartwood, has so far held back from the sector. “Long-term its an allocation for a portfolio that absolutely makes sense owing to the strength of sovereign balance sheets,” he says.

“We’ve traditionally invested in gilts, Treasuries and Bunds, but every time there is an event such as another Greece bail-out, the German Bund deteriorates more and at some point the market will begin to recognise that.”

ETFs are a less favoured option as a broadly based index will generally include assets no-one wants to touch, such as Greek bonds.

View from Morningstar

Just another asset class

Once upon a time investors used to regard developed economies as safer bets compared to their emerging counterparts. These days, however, Western countries have been experiencing serious financial trouble, while economic growth appears to be in the emerging markets’ camp. Developed economies’ stockmarkets are in turmoil and on the bonds front emerging markets seem less and less risky when Eurozone countries, could be forced to default.

But emerging markets bond funds carry certain risks. Fund managers in these areas have different strategies. The Renta Emerging Market Debts fund, for instance, invests in bonds denominated in hard currencies (mostly in US dollars, euros and partly in yen). The fund succeeded in avoiding defaulting countries (first Argentina and then Ecuador), while its portfolio demonstrates low credit quality and extreme interest rate sensitivity.

Other funds include the Schroder Emerging Market Debt Absolute Return which has better credit quality and limited interest rate sensitivity. Indeed its returns are lower, but the fund exhibits lower volatility than the sector average, which can be explained, among other things, by the fact that the fund doesn’t hesitate to develop a strong cash position when in doubt, and by its preference for government rather than corporate bonds.

Another risk factor associated with emerging market debt funds is currency. Emerging countries’ currencies are generally expected to appreciate due to economic growth. European investors should nevertheless be aware that currency risk may not always have a positive outcome.

Frederic Lorenzini, director of research, Morningstar France