Written By: Kenneth Tomlin
& Alexander Kozhemiakin
2012 brought with it signs of a tentative economic recovery in the US and a soft economic landing in China, while new liquidity mechanisms were successfully implemented in Europe. Nevertheless, the fiscal concerns that continue to affect developed economies have undermined the widespread notion that the government bonds issued in those economies are largely free of credit risks. By investing in emerging market economies, investors stand to benefit from portfolio diversification away from developed economies, which are facing serious long-term challenges. Furthermore, emerging market local currency bonds represent an investment in both the currencies and local interest rates of emerging economies. The average credit quality of the local bond universe is investment grade and, historically, currency returns have made the greater contribution to total return, although duration risk has been a steady contributor as well.
Kenneth Tomlin (KT): What do you see as the greatest source of returns within the asset class at present?
Alexander Kozhemiakin (AK): We believe that the current environment is more favourable to gains from currency exposure than duration exposure. Emerging market currencies should benefit from economic growth continuing to exceed that of developed economies, as well as the accompanying inflows of capital. The Mexican peso is, in our view, undervalued from a long-term perspective. It has remained supported by the rising oil price, and the Mexican authorities have been reluctant to intervene to stem the appreciation of the currency. Elsewhere, we favour the Malaysian ringgit, South African rand and the Brazilian real. The investment case hinges on the potential for further currency appreciation; there is strong evidence linking economic growth rates to the performance of credit spreads and currencies.
KT: Do you expect emerging market local currency bonds to remain supported by strong economic growth?
AK: Steady economic growth in many emerging economies over the past decade has coincided with a significant improvement in the creditworthiness of those economies. This, in turn, has led to the tightening of government bond spreads and the strengthening of currencies. We expect the economies of emerging countries to grow at around 4-5% this year, with outliers such as Indonesia, Peru, Chile and Colombia experiencing the greatest expansion. Our outlook for South African and Mexican local duration is positive. Hungary, which remains buffeted by fiscal problems and the impact of the European crisis, is a notable exception that bucks these positive trends.
KT: Can you explain the diversification benefits associated with investing in the asset class? AK: The fortunes of emerging economies, although intertwined, are not interdependent, which allows investors to diversify their exposures to the currencies and local interest rates of different countries. This means that the risks associated with investing in a single country are reduced. Although systemic risk cannot be diversified away, emerging economies, despite not being immune to the Eurozone sovereign debt crisis, are buffered by strengthening domestic consumption and greater trade among each other. The less advanced financial systems of emerging economies have in the past been regarded as a risk factor. However, having had only intermittent access to international capital markets, many emerging economies avoided overextending credit, and Latin American countries in particular exhibit relatively strong balance sheets as a consequence of experiencing their own debt crises during the “lost decade” of the 1990s. With developed economies facing significant long-term challenges, we believe that many emerging economies offer a more favourable investment environment.
KT: What accounts for the relatively high yield offered by emerging market local currency bonds?
AK: On account of the perceived risks associated with investing in emerging economies, emerging market government bonds pay coupons that are, on average, higher than those paid by their developed market counterparts. This differential has been exacerbated by the fact that interest rates in developed economies continue to languish at record low levels. Investors in emerging market local currency bonds could expect to benefit from an average yield of around 6%, making for an appealing risk/reward profile.
KT: How do you manage the risks associated with investing in emerging economies?
AK: Clearly not all emerging countries have deep and liquid capital, currency and swaps markets, along with a local investor base; we are wary of the risks involved in investing in the local currency bond markets of these countries. An assessment of a country’s institutional framework, strength of the rule of law and creditworthiness is essential, as is a thorough understanding of local bankruptcy laws, pay-back arrangements and creditor rights. On this front, emerging countries have made great advances over the past decade, countering the view that they invariably fall within the most vulnerable segment of the global economy. We, however, remain cognisant of the risks associated with a potentially volatile asset class, and believe that the emerging market local currency debt market provides attractive opportunities for those investors that are best prepared to manage the risks appropriately.