Despite some very prominent bumps in the road, Emerging Markets (EM) have been one of the key financial markets success stories of the last two decades. Significant structural changes to the way these economies are governed have facilitated large capital inflows, in turn leading to a significant shift in international investors’ asset allocation trends. EM exposure is now part and parcel of most investment portfolios, with investors lured by comparatively high returns and an increasing perception of diminishing risk.
It is a fact that most EM economies--particularly in Asia and Latin America--have weathered the current crisis much better than their developed counterparts. The current account surpluses accumulated in the years prior to the global financial crisis allowed most EM governments to avoid the slippery slope of higher borrowing to put into place comprehensive stimulus packages during the worst of the downturn. As a result EM creditworthiness has increased, with some EM government bonds now yielding less than those of troubled developed economies--particularly those of the eurozone periphery--which are now seen by some as unworthy holders of the prized "developed" accolade.
Conventional wisdom says that prospects for the future remain fairly bright, with EM economies poised to continue outpacing their developed peers by a sizeable margin. However, as with everything, risks do exist. The success of many EM economies has been predicated on an export-oriented model whereby they have become the suppliers of choice to consumption-driven developed partners. As the latter struggle under the burden of public and private debt, emerging economies may have little option but to promote their internal sources of growth in a decisive manner going forward. This could prove a slow process. In fact, it could be argued that in order to incentivise domestic discretionary private consumption, EM economies may have to develop and/or considerably extend publicly-funded social safety nets (e.g. pension and health provision). If so, this would lead to increased government expenditure--and potentially higher bond issuance--which would take some of the shine off the good budget readings investors have got used to.
Another commonly cited advantage of EM debt is its low correlation with more traditional fixed income investments. The following correlation matrix clearly shows that over the last 10 years EM debt, represented by the JP Morgan EMBI index, has been more closely correlated with equity and non-investment grade (e.g. High Yield) assets than with investment-grade developed countries government bonds. This affords investors a relatively easy way of diversifying their portfolios while picking up yield.
The Specific Case for Local Currency Emerging Market Debt...And the Risks
Before becoming the macro success story of today, EM bond issuance had to be almost exclusively undertaken in foreign currency--mostly US dollars--in order to make it palatable to wary investors in developed markets. The shift in risk perceptions, particularly over the past decade, has allowed for a steady increase in local currency bond issuance, with EM governments seeing this as key to improving economic management by reducing their vulnerability to currency mismatches.
The improving macroeconomic background over the past decade has translated into steady EM currency appreciation vis-à-vis developed economies’ currencies. As such, the attraction of local currency EM bonds has rested on the twin pillars of relatively high yields and currency gains, with the latter having increased in prominence as an influence on the returns equation since the outset of the crisis. In fact, it would be fair to say that a considerable number of the long positions taken on EM debt over the past few years are nothing but disguised currency trades.
In our view, in the high yield/currency gains combo driving EM debt returns, the foreign exchange factor is the one posing the main volatility risks to investors in EM debt. Investors in developed economies would do well not fooling themselves into believing all the hype about a swift development of internal sources of growth in EM. Many of these economies’ macro foundations remain structurally export-oriented and their economic policies remain fundamentally geared to serve this model. And this requires competitive exchange rates. The high level of foreign reserves held by EM governments is but the clearest expression of the political goal of keeping local currencies on a competitive footing. The problem is that what worked relatively well in the pre-crisis years (e.g. massive purchases of USD-denominated assets) is proving less effective nowadays. Besides, over the past few years EM governments have been dealing with a high inflation problem. Tighter monetary policy settings to fight inflation came to compound the local currency appreciation problem (e.g. classic carry trades).
As a consequence, some EM governments have implemented ad-hoc measures against speculative capital inflows. For example, in late 2009 Brazil imposed a 2% tax on foreign portfolio investments and Taiwan restricted overseas investors from buying time deposits. By mid 2010, the list of EM countries which had introduced currency control measures had extended to Indonesia (e.g. minimum holding period for certain securities) and South Korea (e.g. limits on currency forward positions), while Brazil had increased the tax it charges foreigners to buy local bonds to 6%. In most cases these ad-hoc measures have come to complement existing legislation on currency control; this being a routinely cited obstacle to investing in EM. Additional policy moves of this kind cannot be excluded; hence the volatility risk on that side of the returns equation.
Local Currency Emerging Market Debt ETPs in Europe
ETFs offering exposure to local currency EM debt are a fairly new addition to the European exchange-traded product market, with the longest-running fund having been launched in May 2011. According to data sourced from Morningstar Direct, as of end September 2011 there were three local currency EM debt ETFs--all physically replicated--trading on European exchanges.
As per usual when dealing with fixed income instruments, investors should be aware that the level of exposure gained to a given market would vary in relation to the index of reference an ETF tracks. In this particular case, the three ETFs listed offer varying degrees of exposure as each tracks a different index. Not that this is patently obvious to the naked eye if one were to judge by the names with which two of these ETFs are being marketed. Indeed, both the SPDR and iShares traded funds are being sold under almost identical marketing identities (e.g. Barclays Capital EM Local Bond ETF) despite the fact that each tracks a different Barclays Capital index (e.g. BarCap EM Local Currency Liquid Government Bond Index in the case of the SPDR ETF and BarCap EM Local Currency Core Government Bond Index in the case of the iShares ETF) offering a very different level of exposure to the EM government bond market. Meanwhile, the Source PIMCO ETF tracks the PIMCO EM Advantage Local Currency Bond Index. Prospectuses and factsheets do clearly state the index that each ETF tracks, while providing a good explanation of the level of exposure investors would gain to the EM government debt market. Still, while agreeing that it is ultimately down to investors to do their research, it would help if ETP providers were not to make things more difficult than they should really be.
Delving deeper on the issue of market exposure, both the BarCap EM Local Currency Liquid Government Bond Index tracked by the SPDR ETF and the BarCap EM Local Currency Core Government Bond Index tracked by the iShares ETF are sub-sets of the BarCap EM Local Currency Government Bond Index, a benchmark that tracks the performance of 20 local currency EM government debt markets spanning Asia, Latin America, Europe, the Middle East and Africa. The BarCap Liquid index used by SPDR restricts bond selection to bonds with outstanding above $1 billion and limits individual country exposure to 10% of the index. As we write, the Liquid index comprises 17 EM countries. Meanwhile, the BarCap Core index used by iShares only covers 8 countries (e.g. Brazil, Mexico, Poland, Hungary, Turkey, South Africa, Malaysia and Indonesia as of writing), selected on the basis of having the most liquid and accessible local currency bond markets. The eight countries are weighted by market capitalisation, while eligible bonds must have a minimum outstanding of $750 million.
The PIMCO EM Advantage Local Currency Bond Index used by Source tracks the performance of a GDP-weighted basket of EM local currency bond markets, subject to a maximum exposure of 15% per country. As we write, the number of countries included in the index is 12, including the likes of China and India, none of which are part of either of the BarCap indices tracked by the SPDR and iShares funds. However, it must be noted that the PIMCO Source fund uses non-deliverable currency forwards quoted in USD instead of the physical local currency bonds to represent certain countries--including China and India--in the ETF’s basket as a means of circumvent stringent access barriers to these markets.
The base currency for the three ETFs is USD, meaning that all transactions within the fund (e.g. creations, redemptions) are carried out in USD. This means that potentially there is a three-way FX angle to investing in one of these funds: USD-denominated creation/redemptions to buy/sell local currency EM-denominated assets making up the portfolio of an ETF that trades in EUR or GBP in the local European exchanges. Although there is a clear logic to this operational method--in fact it is not unique or purposely difficult--it is also clear that this FX jigsaw is only likely to be easy to handle by institutional and very savvy retail investors.
The very short market run of these three ETFs makes it difficult to predict whether they will prove a success story in the long-run. Nevertheless, we can only welcome their arrival as a further sign of the ETP providers’ commitment to facilitating access to all sorts of asset classes.
Further Reading
Diversifying with Emerging Market Debt
Emerging Market Debt: Beyond Divesrification
