With its lower volatility and higher recovery rates, emerging market debt has been a far better bet than equities, a situation that looks set to continue as these nations develop further
Within emerging markets, debt has outperformed equity markets over the past 13 years. Macroeconomic improvements in the emerging markets regions have helped to increase debt returns, produce higher coupons and reduce its volatility level. Investors have also been attracted to this asset class as it is transparent and they can invest in it through hard currencies, which reduces the risk.
Debt has proven a much more attractive way to participate in the overall macro improvement seen in a number of developing countries, as emerging market government bonds have generally traded as a proxy for how well a specific country is faring. So when one considers the trend of better governance, improved fiscal positions and political stability, it is easy to recognise the improvement in credit quality.
The rating agencies now consider 40% of the emerging market debt universe to be investment grade, more than double the figure of 10 years ago. As testament to this improvement there has been a shift from repackaged US-backed debt (Brady bonds) to plain vanilla bonds backed purely by the respective emerging market sovereign. Emerging market equities, being more micro-focused, have not necessarily benefited as much from these positives.
Power of Income
The attractive coupon on emerging market bonds has been a stronger driver of performance when compared to the lower dividend yield available on equities. Over time, this has significantly added to performance no matter how risk averse the market has been. As bonds mature at par, the powerful combination of high coupon income (8% to 11% typically) coupled with the final payment of capital is very compelling when one considers the historically low interest rates available to G7 investors.
Debt is considered the more liquid asset class and has exhibited lower volatility. Emerging market bonds have high recovery rates even when taking into account the historical defaults and rescheduling, an event that can be catastrophic for shares. Unlike companies, countries continue to exist even when they fail to service their debt. The capital markets provide much-needed financing for the benefit of a country's citizens and the government's need to stay on reasonably good terms with investors to keep the costs of such financing low.
Whereas equity markets are traditionally more locally focused, external emerging market debt has generally been held by international investors, who have tended to demand a much higher level of information and transparency. This has led to the debt markets being more efficient as an asset class.
Hard Cash Exposure
Also, emerging market equity investors are typically exposed to the sharp movements in local currencies, while most G7 investors in emerging market debt have typically purchased dollar or euro-denominated debt, which has generally been considerably less volatile.
One of the best ways to make money out of emerging market debt is to aim for total returns with low volatility. Individual securities should always be selected on a total return, low volatility basis. The macroeconomic and political environment should determine the entry and exit points, while the decision on the library from which individual securities the portfolio managers may buy should be determined a thorough credit risk analysis process. Investors should seek attractive yields but should only invest when they believe in the underlying case after thorough independent fundamental analysis.
In emerging markets debt, it is also time to be an absolute return investor rather than index tracker, due to the fundamental flaws of indices in this asset class. Compared to equity indices, fixed income indices have a negative bias. This means the more profligate and risky a country is, the larger its share of debt in the index becomes. There is little safety in having a large exposure to any one country or company where the risk of default or restructuring exists. A good example of such a credit has been Argentina in the early part of the decade. An index investor would have had to endure significant exposure to a deteriorating credit story up to its eventual default and restructuring.
the future of debt
For the reminder of 2006 and early 2007 investors should expect to see a rally in US and global government bonds. But this is based on the premise US treasuries will remain vulnerable to bouts of volatility as investors modify their inflation and future interest rate expectations.
Either way, corporate or emerging market spreads should not widen significantly, as the base case scenario is for a shallow, but prolonged global economic slowdown in the next 12-18 months.
Global liquidity should remain strong and the search for yield will possibly get stronger once central banks retreat to more dovish policies due to weaker housing markets and/or a slower global economy. Such actions should partially or wholly offset concerns over deteriorating credit quality and some weakness that will likely flow from the US into both developed market corporate bonds and into a number of emerging market economies.
Furthermore, a combination of the structural improvements in a number of emerging market economies and significant investment flows over the last few years should keep emerging market spreads relatively well-underpinned. As a result, emerging market bonds should outperform high quality bonds over the next 12-18 months.
Meanwhile, in recent months, there has been a shift in emphasis away from sovereign bonds, which are generally expensive, and into a number of interesting corporate credit opportunities in emerging markets.
Investors should be bullish over the prospects for emerging market corporate bonds in Russia, as the Russian economy is in the midst of a multi-year expansion period. The country has benefited strongly by the surge in commodity prices, better governance and strengthening business and consumer sector. As a result, its society is progressing to the next stage of the consumer cycle, which has led to the development of such markets as those in retail, credit, housing and mortgages. Current Russian sectors to favour are retailing, property and aerospace.
Elsewhere in the former Soviet bloc, investors should have a preference for Kazakhstan, with selective exposure in the Ukraine. In particular, managers have been positive on the Kazakh banking sector, which is experiencing growth similar to that in Russia.
There have also been a number of opportunities from Indonesian companies as they have been active in the new issue market over the last several months, and offer the investor very attractive yields. Preferred themes include the resource, property and retailing sectors. Outside of Indonesia, exposure in Asia tends to be more individual situations-driven than thematic.
Going forward emerging market debt should remain an attractive opportunity for investors. As growth in these regions increases and the macro economic environment stabilises, countries will get re-rated, which will be a boost for emerging market debt investors. key points
Emerging market debt has outperformed equities for past 13 years
Emerging market government bonds have generally traded as a proxy for how well a specific country is faring
Russia's continued expansion is benefiting corporate bonds
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress