Making the investment grade

December, 2012 Print

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Brett Dimett

Head of Emerging Market Debt

Aberdeen Asset Management

 

The current global climate has left developed market bonds delivering negative real yields, forcing investors to leave risk-free assets and look much farther afield for income sources, while in turn taking on extra risk. In many cases, this has meant investing in high yielding bonds, often referred to as “junk” bonds, with suspect average credit ratings. Emerging market debt as an alternative source of return has often been overlooked and long been regarded as a highly unstable asset class, associated with bouts of volatility, elevated borrowing costs, currency devaluations, high political risk and episodes of default, making it suitable only for professional investors. Over the last 20 years, economic reforms, improved governance, increased industrialisation and positive demographics have all played a part in the dramatic development of emerging market economies and, in turn, helped reshape its debt universe to become a suitable investment opportunity for a wider range of investors.

The turning point for emerging markets came with the 2007-09 financial crisis when the emerging world, even though not spared the adverse effects, was generally less affected than the developed world, and took over responsibility as the engine of the global economy. The shift in the balance of world power is clearly marked by the replacement of G7 with G20 as the world forum for policymakers. This could be considered a natural development given that emerging markets now account for almost 50% of the world GDP in terms of purchasing power parity, as estimated by the IMF. Yet, despite accounting for such a significant part of world output and 80% of the world population, emerging markets constitute only 0.68% of Barclays Aggregate Bond index1. This is likely to expand meaningfully in the years to come as the asset class grows and matures and thus there is a wealth of opportunities to be explored.

The key rationales behind investing in emerging market debt can be summarised by “3Ds” – Disinflation, Demographics and Debt Dynamics.

Disinflation

High inflation in the emerging economies in the 80s and 90s has previously deterred investors from seriously considering emerging market investments, especially those denominated in local currency. Emerging market central banks, influenced by political considerations, often found it difficult to meet inflation targets. Political reforms have led to central bank independence and most emerging economies have now successfully battled inflation. Many of the countries, such as Mexico and Colombia, are explicit inflation targeters and have had considerable success remaining in their inflation bands. This has resulted in the stabilisation of inflation with largely consistent and appropriate policy interest rate changes. Emerging economies across all regions have been recording a steady decline in inflation levels, increasing their credibility amongst investors. Improving local and foreign investor appetite has enabled governments to issue bonds with longer maturities.

Demographics

Currently, more than 25% of Japanese and in excess of 14% of American, UK and Eurozone citizens are over the age of 65. These figures are likely to increase over time, which will limit economic growth. In contrast, in the majority of emerging market economies the proportion in retirement is still in single digits. Growing youthful populations and burgeoning workforces are enhancing earnings and spending power, driving domestic growth and lessening dependence on the developed world.

Debt Dynamics

Historically, governments in these regions used debt to help fuel growth. However, prudent fiscal management and economic prosperity led to deleveraging, as governments repaid debt and reduced their budget deficits. The improved fiscal balances have resulted in greater stability, making emerging economies more resilient in the face of financial turbulence, and at the same time improving their standing in the international financial markets. The healthier backdrop has been necessary for an improved political and business environment. Meanwhile, debt in the developed world has been rising for many years – which has created a debt overhang, limited fiscal flexibility, lowered growth potential and increased investor risk.

Emerging market debt can also provide significant diversification benefits with a low historical correlation to developed markets and emerging market equities, suggesting that it can play a valuable role in a balanced portfolio.

 

 

Access all areas

Investors can access emerging market debt in a variety of ways. Traditionally, investors have concentrated on debt denominated in hard currency, usually the US dollar. However, stabilising economies have allowed emerging market governments to raise more and more of their financing through issuing debt in local currency, which is now more than twice the size of the US dollar market. This has helped to reduce emerging economies vulnerability to external shocks. Emerging market hard currency debt and emerging market local currency debt should be considered two distinct asset classes. The two feature different credit quality and regional compositions, and respond to different drivers of return. Emerging market local currency debt has explicit exposure to currency and interest rate dynamics, and an investor base dominated by local institutional investors. By contrast, hard currency emerging market debt is ultimately a “spread product”, meaning it is compared to the yields on other comparable sovereign debt instruments.

A third type of emerging market debt is corporate debt, which in recent years has developed into a standalone asset class. Previously the asset class was viewed only as a specialist source of returns for investors seeking “risky” returns. Emerging market companies have grown to be fundamentally healthier than developed market companies, boasting lower leverage, higher quality of cash generation and better ability to pay back their liabilities. Dedicated financial infrastructure such as investable market indices, dedicated research and the rapid growth in market capitalisation from increasing issuance has brought this burgeoning asset class into the spotlight.

Conclusion

In many ways the world has turned upside down in the past decade. It was not too long ago when developing countries were struggling with heavy debt burdens, high fiscal deficits and low growth prospects. Today, the developed world is faced with the very same affliction. Credit ratings increasingly back up this phenomenon, with the vast majority of emerging markets now classified as investment grade (BBB- or above) while developed world ratings continue to deteriorate. It is likely, and to an extent understandable, that investors will continue to be sceptical of emerging markets in the near term, marred by old habits and “herd-following” tendencies, but as time passes investors should begin to see for themselves the fundamental value the asset class offers.

 

1. Source: Barclays Capital

2. Source: Bloomberg

 

Emerging Markets FOCUS

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