As emerging market economies become more secure, so too does their debt.
Investors who associate emerging market debt with
irresponsible fiscal policy, economic upheaval, debt crisis and wild
volatility may be surprised to learn that many bonds issued by
developing market countries today have a much tamer risk profile than
they did just a few years ago-and in most cases, lower yields as well.
"Emerging market countries have implemented far-reaching structural and economic reforms that have brought down macroeconomic uncertainty quite dramatically," says Owi S. Ruivivar, portfolio manager of the GS Emerging Markets Debt fund for Goldman Sachs' asset management arm. "Over the last few years, GDP growth has become much less volatile. We're seeing far fewer boom-bust cycles that precipitated debt problems in the past, and increased resilience to crisis."
Notable changes include moving from free-floating currencies to fixed exchange rates, which enable countries to enjoy the benefit of more competitive exchange rates and improve their resilience to economic shocks. More conservative policies have created fiscal surpluses in many developing market countries. Rampant inflation has vanished with the move from ambiguous, inflationary monetary policies to those that specifically target the inflation rate. At the end of 2006 the average inflation rate in developing countries was just under 6%, compared to more than 100% in the early 1990s.
The maturation of emerging market economies and their corresponding debt markets has transformed the asset class from one dominated by speculators just a few years ago to a diversifier for more conservative investors, such as pension funds and institutional investors, who had not considered it before. With a 12.4% return for the year ending April 30 and a 14.8% annualized return since its inception in 2003, Ruivivar's fund has benefited from the increased demand.
But that demand has also boosted prices and lowered yields relative to U.S. Treasury securities and other U.S. bonds. At the height of the Asian and Russian debt crises in the late 1990s, emerging market debt yields were as much as 1,500 basis points higher than Treasury bonds of comparable maturity. Six years ago, the difference still stood at a gaping 1,000 basis points. By 2005 it had narrowed to 500 basis points, and today emerging market bonds have a mere 200 basis point advantage over Treasuries. The firm's domestic high-yield debt fund sports a standardized yield of 6.57%, compared to 5.15% for the emerging market debt fund, reflecting the perception that emerging market debt isn't as risky as it used to be.
By some measures, that may be true. Over 44% of the market value of the J.P. Morgan Emerging Market Index is investment grade, up from 30% in 2002 and only about 5% in the late 1990s. The volatility of dollar-denominated emerging market debt has also fallen, and is only slightly higher than that of U.S. high-yield bonds. Sustained or rising commodity prices should continue to support emerging markets, particularly oil exporters. Investor demand is strong and broadening, while supply remains favorable as emerging market countries pay down more debt than they are issuing.
Local Market Plays
The question now is whether strong demand and a more conservative posture for the asset class limits upside potential. Ruivivar thinks that while dollar-denominated bonds do not have a lot of room for appreciation, the increasing dominance of securities issued in local markets will help keep overall returns buoyant.
"Over the last few years emerging market fixed income has evolved into an asset class that includes local market instruments issued in local currency as well as dollar-denominated debt," she explains. "Dollar-denominated or external debt accounts for about $300 billion in market capitalization of the J.P. Morgan Global Bond Index, while the market capitalization for local market debt is just over $400 billion. Three years ago the local currency market space was tiny, and local market indexes were developed just two years ago. This has been a very quick evolution."
Increased demand from local institutional investors such as pension funds, which are moving from an arrangement that drains government resources to a privately financed, capital-intensive system, accounts for some of the growth. Attracted by high yields and wide interest rate spreads relative to U.S. Treasury securities, mutual funds and other international investors have been also buying bonds issued in local markets.
Spreads relative to Treasuries are much tighter among dollar-denominated bonds than local market instruments, and their yields are lower. On average, dollar-denominated emerging market debt yields stand at about 6.3%, compared to about 9.5% for local market bonds. The bonds trade at yields as high as 19% in Turkey and 11% in Brazil.
"Spreads on dollar-denominated securities are likely to remain fairly range-bound at current levels," she says. "Years ago, when spreads relative to Treasuries were 700 basis points and U.S. interest rates were lower than they are today, most of the risk investors took was emerging market risk. With spreads at such tight levels, most of the risk in dollar-denominated emerging market debt is now attributable to U.S. Treasury risk." While that limits a lot of the upside opportunities, Ruivivar still believes that these bonds are useful for portfolio diversification.
She believes local currency bonds, which account for about 25% of fund assets, are a more interesting play. "The outlook here is a lot more promising in terms of valuation," she says. "Sovereign risk and inflation in the emerging market world has declined, and that should correlate strongly with local market yields. But while spreads on dollar-denominated debt have narrowed dramatically, the favorable impact of those developments has not been fully reflected in local markets."
She also believes developing world currencies are undervalued relative to the dollar and other currencies of industrialized countries. Current account surpluses and favorable productivity trends in emerging market countries support the argument for strengthening currencies, which would provide a boost for local currency bonds.
"Certainly, the valuations are more compelling in local markets even after adjusting for the risk of moving into a local currency-denominated bond," she says.
At 14% of the portfolio, Russia represents the fund's largest country exposure. Even though its bonds do not yield much more than U.S. Treasury securities, they provide ballast to the portfolio. "The government factors in oil price assumptions into its fiscal budget and saves the surplus when prices rise above that level to provide a cushion against future declines," she says. "The country has a tremendous ability to pay its debt. Even at low spreads Russian debt is still valuable, given its low embedded risk."
In Brazil, the second largest country position at 10% of assets, the fund owns both in fixed coupon and inflation-linked bonds. "I think that there are a lot of interesting structural changes in countries such as Brazil, where you've had massive disinflation, positive productivity trends and an economy that is assuming a more external focus. This kind of virtuous cycle encourages growth, and has surprised even the Brazilians. It's a very exciting turnaround."
While government bonds are the fund's bread and butter, it owns a smattering of corporate securities as well. Ruivivar says the recent hiring of an analyst to focus exclusively on emerging market corporate bonds represents a step toward beefing up exposure in that higher-yielding area.
About half of the portfolio is in double B-rated securities, where she sees the best values and potential for appreciation. A 21% allocation to triple B paper reflects a strong presence in local markets of countries assigned that rating, such as Mexico and Russia. "We are not particularly ratings conscious and we don't manage the portfolio according to a ratings benchmark," she says. "But we do look for situations where a bond's fundamental value is at variance with the value the market assigns to it."
The fund has a tracking error of between 200 and 300 basis points relative to its benchmark, the J.P. Morgan EMBI Global Diversified Index, a variation that Ruivivar labels as conservative compared to many fund competitors. Country weightings and other deviations from the benchmark are subject to internal limitations that she prefers not to disclose.
The portfolio, which holds about 100 securities from 30 countries, has an overweight position relative to the benchmark in Russia and Turkey. Ruivivar likes the latter country largely because its local market bonds sport yields of around 19%, compared to the global average of 5%. "Frankly, that 14 percentage point pickup is more than enough to compensate for country risk, inflation risk and exchange rate risk," she says.
Other overweight positions include Panama and Uruguay, whose bonds serve as portfolio diversifiers with a very low correlation to other markets. The latter country's currency is undervalued and should appreciate, providing a boost to local market bond holdings. Asia accounts for most of the underweight positions. "It's not that we don't like Asia's fundamentals, but we just don't think there is value to be had there," she says.