Emerging-markets bond funds are attracting more attention these days. Although emerging-markets equity funds still enjoy greater popularity than do their bond-fund counterparts, the Morningstar Emerging-Markets Bonds (Local Currency) category has seen net asset flows of £1.4 billion into UK-domiciled open-ended funds in the 12 months to end-October, and not only because of strong returns so far this year but also due to its dominance over other fixed-income categories across a range of trailing time periods.
Seismic structural shifts have accompanied the emerging-markets bond head-turning performance. The image that prevailed in the 1980s and 1990s of chronically indebted emerging markets no longer applies. Today, emerging economies are not only growing more quickly than developed economies, in many cases they are sounder financially, too. Debt/gross domestic product ratios tend to be far lower than the United Kingdom's approximate 78%, the United States' 93% and Japan's more than 200%. The IMF reckons that the average debt/GDP for the Emerging G-20 countries--including Brazil, Mexico, and Russia--is just 37%. (In fact, Schroders' Head of Emerging Markets Equities, Allan Conway, recently described the developed economies as "dinosaurs"--find out more here.)
These structural changes have helped bring emerging-markets bonds into the fixed-income mainstream, providing an additional source of potential diversification for fund investors. Whereas these funds had once been considered quite speculative, they now seem worthy of a small, strategic allocation in many investors' portfolios.
Won't Be Fooled Again
It wasn't always this way. In the 1990s, many developing countries had far higher debt levels, defaults were a constant threat, and they had to issue bonds in dollars (that is, Brady or Yankee bonds) in order to entice developed-world investors. High debt levels eventually triggered the Asian currency crisis in 1997 and the Russian default in 1998. Debt markets were obliterated in the latter year, with emerging-markets bond funds falling 22.7% on average.
These two traumatic events spurred many developing governments to clean up their balance sheets. In particular, governments wanted to reduce their dependence on foreign creditors and vulnerability to capital flight. With newly devalued currencies improving their competitiveness, these economies were able to export their way out of trouble. (Something developed economies may have a difficult time replicating.)
As a result, emerging debt/GDP ratios have declined and credit quality has improved dramatically. Hard-currency benchmark JPMorgan Emerging Market Bond Index Global (EMBI Global) has an average credit rating of BB+, which is just below investment-grade. And nearly 60% of its constituents are investment-grade. In contrast, only about 5% of emerging-market debt was investment-grade in 1993.
This has led to narrowing credit spreads versus US Treasury bonds as well as fantastic returns for emerging-markets bond funds and free-floating currencies. According to PIMCO, more than 70% of developing currencies were pegged to the US dollar in 1996, but by 2007, 85% of emerging currencies floated freely.
This free float has facilitated the increased issuance of local-currency debt. In some cases, local-currency issuance has even begun to supplant so-called hard currency (namely, the dollar and euro) debt. What's more, fund managers have been buying local-currency bonds in increasing volumes, something that would have been unthinkable a decade ago.
Traditionally, local-currency bond markets were considered substandard. But because only the most financially stable governments--and even fewer corporations--can issue local-currency bonds that outside investors will buy, credit quality there is slightly better these days than in the hard-currency pool. Alternatively, a relatively unstable country such as Venezuela is almost forced to issue debt in dollars.
Consider the following comparison: While the hard-currency EMBI Global index has an average credit quality of BB+, US dollar proxy JPMorgan Government Bond Index-Emerging Markets (GBI-EM) has an average credit quality of A-. Furthermore, despite its higher credit quality, this past summer the GBI-EM had only a slightly lower yield than the EMBI Global: 6.43% vs. 6.48%.
What Does This Mean for Funds?
As issuance has picked up, a handful of dedicated local-currency funds have sprouted during the past three to five years. Some of the largest emerging-markets bond funds available for sale in the UK include Pictet-Emerging Local Currency Debt, PIMCO GIS Emerging Local Bond, GS Global Emerging Markets Debt Local, and Investec Emerging Markets Local Currency Debt. Under the management of Peter Eerdmans and his team, the latter has earned itself Morningstar's Superior qualitative rating (rated A by OBSR, a Morningstar company).
This is not to say, however, that investors should necessarily favour a local-currency fund over a hard-currency fund at this point. There are a number of factors to consider and even managers who run hard-currency funds are dabbling in local-currency bonds these days. Such forays provide an additional source of returns and diversification. (Read more in Diversifying with Emerging Markets Debt.)
Valuations
While the economic fundamentals in emerging markets look bright, that doesn't necessarily mean returns will continue at their previous clip. Many managers we have spoken with are neutral on valuations overall. Therefore, investors should keep their short-term return expectations in check.
Due to increased interest in the asset class, credit spreads over US Treasuries have tightened considerably. Spreads peaked at about 1,400 basis points in 1998 after the Russian default, but this past summer they were closer to 350 basis points. To be sure, credit spreads were far narrower before the credit crisis three years ago. Still, investors shouldn't necessarily expect returns to be as robust as they have been over the previous decade.
Finally, always keep risk clearly in mind. While emerging markets appear poised to join and possibly supplant developed markets at the table, that doesn't mean risk has been eliminated. Indeed, many of the positive structural improvements mentioned above were already in place in 2008, and yet the average emerging-markets bond fund still dropped nearly 18% that year. Old attitudes die hard, and emerging markets could still be vulnerable to capital flight should there be a repeat of 2008. Thus, these funds require a long-term commitment, rather than an opportunistic one.
Kevin McDevitt, CFA is Editorial Director for Morningstar.com. This article was adapted for a UK audience, with updated and regional statistics, by Holly Cook, Editor of Morningstar.co.uk.
