To the surprise of many, emerging-market debt has performed well.
In the universe of emerging-market finance, spectacular international flameouts are common. The Asian contagion spooked the financial markets in 1997, while Russia, getting itself entangled with Long-Term Capital Management, tripped up a year later. Argentina registered the biggest sovereign default in history in 2001, and around the same time Brazil and Ecuador experienced their own financial tantrums. When you add the dramatic slowdown in the global economy in recent years to this international dishonor roll, observes Mohamed A. El-Erian, a Pimco managing director, "You couldn't imagine a worst set of circumstances."
The gloom, however, shrouded a curious trend that very few people initially noticed. Despite bleak dispatches from distant time zones, emerging-market debt was making money for its investors. In fact, tons of it. Take a look at Morningstar's top 25 bond funds for the last five years and you'll notice that each one is devoted to emerging-market debt. GMO Emerging Country Debt IV, the No. 1 fund during the period, generated a five-year annualized return of 26.59% through September 30. The average emerging-market bond fund, over that five-year time period, returned 19.18%. Even more impressive: During the past 13 years, emerging market debt has reigned as the world's best-performing asset class.
With stats like these trickling out, speculators have been throwing money at debt in places like South Korea, Chile, Poland and Russia. More cautious investors, hungry for yield in this miserly, low-interest-rate environment, have followed along. According to Lipper, today's emerging-market debt funds are offering an average yield of 7.05%. Meanwhile, the cash flowing into this niche fixed-income category in 2003 from pension funds, endowments and other institutional investors has hit historic highs.
Yet the vast majority of retail investors don't even know the asset class exists. "This is an undiscovered part of the financial world," observes Bill Nemerever, partner and co-head of the group that manages global bonds at Grantham, Mayo, Van Otterloo & Co. It is also an asset class, Nemerever adds, that "can scare the hell out of you." During the Russian crisis in 1998, for example, the average emerging-debt bond fund plummeted 34% in just three months. Not the sort of volatility that a retiree who cozies up with Treasuries could stomach.
For investment advisors the question remains, is emerging-market debt a legitimate asset class? Many experts suggest that it is. They feel comfortable vouching for these mercurial bonds because of fundamental changes within the countries that are issuing this debt, as well as outside economic forces. "The asset class has gradually matured in terms of creditworthiness, information accuracy and availability, market infrastructure and investor base," observes El-Erian, who heads Pimco's emerging-markets portfolio management. On the other hand, some advisors insist that the guy hoarding the Treasuries has the right idea. Play it ultrasafe with a portfolio's fixed-income side, and leave the risk-taking for equities.
Perhaps the most visible proof that emerging debt is shedding a bit of its Molotov cocktail image is the dramatic improvement of its credit quality. Five years ago, less than 10% of debt in the emerging market indexes was investment grade, but today more than 40% is. Within the next few months, El-Erian predicts, 60% of the debt will earn that distinction. These bonds gained even more respectability in October, when Moody's Investors Service announced that Russia's debt, which just five years ago was in default, was being elevated to investment grade.
Numerous reasons exist for the turnaround. First, many emerging countries have developed sounder fiscal policies, including establishing independent central banks and overseeing flexible exchange rates. Having learned from previous government crises, Asian countries as well as other emerging nations such as Russia, Poland, Mexico, Brazil and Ukraine, have built up their international reserves, which could act as shock absorbers during times of crisis. On the liability side of the ledger, nations have been shedding their debt. Every region in the emerging world can point to improved current account balances.
In looking for global opportunities, money managers primarily invest in debt issued by governments, not corporations, making sovereign bonds this asset class's prime attraction. It's a distinction that some experts use to explain why this debt has outsprinted emerging-market equities, a favored asset class that's far more likely to be found in sophisticated asset allocations. (During the past five years, according to Lipper, the average return for emerging-market equity funds has been 10.75%, which is a whopping 843 basis points behind emerging-market debt funds.) When nations experience financial troubles, they can protect their bondholders and their own hide by raising taxes, cutting spending and bumping up interest rates. In the process, many countries shift the financial burden to equities, which can get creamed.
What also attracts investors to emerging-market debt is its low correlation with other investments-at least some of the time. "In relatively good times, emerging-market bonds seem to have unique return characteristics," says Campbell R. Harvey, professor of finance at Duke University and co-editor of the Emerging Markets Review. Correlation, however, often surfaces when it's least welcome. "In times of crisis," he says, "returns are highly correlated with equity market returns."
Despite the recent interest, emerging debt remains a bit financial player. There's only about $500 billion to $750 billion worth of tradable emerging-market debt. One reason for its relative obscurity is its brief existence. The asset class was born in the late 1980s when bank loans were securitized into Brady bonds. Although Brady bonds first appeared in Mexico, within the decade they had spread across Central Europe, Latin American and Africa. Today, Brady bonds represent less than half of the emerging-debt market.