Emerging Markets Debt is an asset class that has attracted significant inflows in recent months, reflecting growing interest in a part of the market that until only several years ago was a niche reserved for the most daring. Over the past decade, a combination of steady inflows and positive returns have seen assets grow from under $300 billion in the beginning of the decade to over $1.2 trillion this year. The growth was interrupted during the financial crisis, but this was short-lived and inflows resumed in full force as investors started seeking risk exposure outside of the traditional asset classes and geographies.
In fact, among open-ended funds available for sale in Europe, Emerging Markets Bond funds as a group attracted the largest net inflows of any group of funds for the one year period to the end of August 2010, topping the other peer groups with over EUR 30 billion of inflows over the period. A distant second are Emerging Markets Equity funds, which saw inflows of over EUR 18 billion. Over the same period money market funds, considered the safest vehicles among mutual funds, saw the largest outflows by a mile compared to other types of funds, to the tune of over EUR 200 billion. (Source: Morningstar Direct, data as at 30/08/2010.)
The Case for Emerging Markets
Assets in emerging markets have attracted strong inflows on the back of positive economic prospects. Compared to the developed economies of the US, Europe and Japan, emerging markets economies (notable representatives being China, Brazil, India, Russia, Latin America and Eastern Europe) are appealing for several reasons.
Firstly, emerging market governments’ fiscal positions are generally on a better footing, with significantly lower levels of debt as a percentage of GDP and significantly lower projected future liabilities for services such as social security and state-provided healthcare. Stronger fiscal fundamentals allow greater flexibility in government policies, especially when they relate to the ability to maintain low taxation levels and encourage economic activity. Governments’ strong fiscal positions also favour their ability to service their debt, which is especially important since the bulk of emerging markets debt securities are issued by the governments of those countries.
Secondly, debt levels in the private sectors are generally lower, to a large degree owing to higher savings rates and a comparative aversion to using leverage as a means to boost wealth. This means that consumers are generally in a better position to spend, with domestic consumption becoming a larger growing proportion of GDP at the expense of exports. Finally, from a demographics perspective emerging markets have the benefit of a younger population and a more flexible labour force.
On the basis of the above, there is a strong case for economic growth in emerging markets. And while those countries as a group contribute about a third to global GDP, they contribute more than half to global GDP growth, contribute a third to global trade, and are home to over 80% of the world’s population.
The Appeal of the Asset Class
For long term investors seeking diversification, the major appeal of emerging markets debt as an asset class is in its low correlation to other assets, and hence the diversification benefit it provides to a portfolio. This is demonstrated in the correlation matrix below, which uses sterling-denominated returns for each category over the 10 years up to end-September 2010.
The category’s correlation, shown in the first column, against a common set of asset classes fluctuates between 0.46 and 0.71, which means that it would add significant diversification to a portfolio composed of those assets. This benefit, combined with an attractive long-term sovereign and currency risk profile as emerging markets economies continue to strengthen and stabilise fiscal and economic policies, as well as the generally higher yield produced by emerging markets government bonds, is a good reason to keep the asset class in mind.
Things to Keep in Mind
While broad economic rationale favours emerging markets, investors should keep the following in mind:
Firstly, because debt instruments pay a fixed coupon to their owner, they cap the upside potential for return. Hence, economic fundamentals are important to the extent that they improve a government’s ability and willingness to service its debt. For investors looking for a direct participation in economic growth, equities may be the better suited financial instruments.
Secondly, emerging markets debt carries a higher risk of government default, given that emerging markets governments have a history of defaulting on their debt (notorious examples are Argentina in 2002, Russia in 1997, and Mexico in 1982). While the sovereign risk premium (the additional yield that investors demand for bearing the higher risk of government default) has been on a steady decline since the early 2000s, it recently exploded in the wake of Greece’s woes and the ensuing losses for emerging markets bonds were a painful reminder of this risk.
Finally, bonds issued in local currencies, as opposed to ‘hard’ currencies such as the US dollar and the euro, are additionally exposed to domestic inflation and fluctuations in the value of the domestic currency. As global perceptions of what is ‘emerging’ and what is ‘developed’ are shifting, the bulk of new issuance is of debt denominated in local currencies, and this is also the segment of the market that has attracted the majority of the inflows. With global bond yields depressed in an all-time low interest rate environment and with sovereign spreads tightening, the major portion of returns from the asset class have come from the currency element, including the fluctuations of local currencies against the dollar and the euro and a general reduction in the currency risk premium.
All in All
For knowledgeable investors aware of the risks, emerging markets debt as an asset class provides a welcome opportunity for diversification within a well constructed portfolio.
This article was originally published October 2010.
Morningstar Consulting Europe
Morningstar Consulting Europe engages with a variety of institutional clients, including investment firms, insurance companies, banks, plan sponsors, plan providers and foundations. The comprehensive array of solutions provided includes portfolio construction and management, strategic asset allocation, manager selection and investment governance/monitoring.
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