Investors may want to consider government and corporate bonds from emerging markets (aka emerging market debt) as they hunt for returns. Investing in emerging market debt is similar to travelling: you can now fly relatively easily and cheaply to every corner of the world, but that does not mean you should do it. A common-sense traveller would avoid unsafe areas and a bond investor should also keep this in mind.
A private investor interested in emerging market debt would likely want to appoint a fund manager to help him access these markets
Outside investors do not always have easy access to local credit markets in emerging countries, there are sometimes capital restrictions for foreign investors, there may be withholding tax levied and there can be other legal and regulatory obstacles.
“The path to return with emerging market debt leads through landmines", warns William Ledward, senior vice president and portfolio manager with the fixed income group at Franklin Templeton. “However, it remains a very promising asset class”, he said.
Four Flavours of Emerging Market Debt
Emerging market debt comes in four key ‘flavours’:
1. Government bonds denominated in developed-market currencies
2. Government bonds denominated in local currencies
3. Corporate bonds denominated in developed-market currencies
4. Corporate bonds denominated in local currencies
There are many diversification opportunities using these different ‘flavours’. Furthermore, investors can choose to invest in debt with different yield curves. These options make it complex for investors, and Ledward says that a private investor interested in emerging market debt would likely want to appoint a fund manager to help him access these markets.
“It is extremely difficult for private investors to do all the homework themselves”, he said.
Emerging Market Debt: Government Bonds
Government bonds denominated in developed-market currencies, such as sterling or US dollars, is the most mature category for emerging market debt. Initially, issues of government bonds from emerging countries had to take place in US dollars to win over suspicious investors. However, over time investors have come to feel more relaxed owning debt from emerging economies. As a result of this changing perception to risk, governments in emerging countries have also been able to issue bonds in local currencies. Investors are now attracted to emerging market debt that is denominated in local currencies because these investments tend to offer high returns and the potential for foreign-currency gains. But investors should note that emerging market currencies can also suffer from extreme volatility relative to developed-market currencies.
Many emerging countries can be highly complex and difficult to access, said Ledward. For example, China and India are not easily accessible for foreign bond investors and Brazil levies an 'entry tax' that must be paid in advance.
“That tax means you already start with a 6% loss on your investment. Such measures were taken because Brazil was afraid that a great demand for its Real would lead to a higher exchange rate for its currency. There has also been a lot of volatility over the past year due to depreciating currencies”, he said.
In addition, the economic policies of emerging countries are fundamentally based on an export-oriented model, which requires competitive exchange rates. Investors should be aware that governments in these countries will not hesitate to use ad hoc policies in an attempt to stop the appreciation of their local currency.
Getting in is Tough, But Getting Out is Worse
Ledward warns that he has experienced an instance where he could not take his money out of an emerging market. “It took us a year to get out of Malawi,” he said, but would not elaborate further.
“Egypt is also a country surrounded by uncertainties,” he said. “The Central Bank of Egypt does not want you to convert your bond in the Egyptian currency into US dollars, for example. You essentially do not know the exchange rate at which you can leave the country. Sometimes your money becomes trapped in a country, and you can do nothing except reinvest there”.
For investors considering government emerging market debt, they should bear in mind that it is much more accessible, liquid and easier to exit if you are using developed-market currencies instead of local currencies.
Emerging Market Debt: Corporate Bonds
Of all the different ‘flavours’, the newest type is the corporate bonds that are issued in local currencies.
“The appeal of corporate bonds in local currencies is that they are a natural currency hedge, because the economies are often export-driven”, said Ledward.
Despite the risk of bankruptcies and volatility, bond connoisseurs know that corporate bonds from emerging economies should not be missed. There are certainly bargains to be found.
Ledward identified 
Cemex (CX) as one such bargain. This Mexican cement producer had the status of investment grade but became a fallen angel. Cemex always ignored the bond market, but after several bad investments it lost its creditworthiness and could no longer go to banks. Nevertheless, Ledward considers its underlying activities to be good. “When everything is at its blackest, it is time to buy. We have benefited from the pessimism surrounding Cemex”, he said.
“But you must still be vigilant,” said Ledward. “Corporate governance is still an issue, and some businesses are run by crooks. There are enough landmines that explode if you step on them. Ideally you should have small positions so that the damage is limited”.
Ledward had such a landmine in his portfolio last year that exploded. “We lost a considerable amount and the damage was not pleasant. However, the mine did not kill us, and fortunately it also did not destroy the annual return in the fund”.
An interesting category in corporate debt securities, according to Ledward, is what he calls "quasi-government bonds". These are bonds issued by private, listed companies in which the government is heavily involved. This category includes national railway companies and oil and gas producers, such as Petrobras (PBR).
Beware of the Hype
As people increasingly turn to emerging market debt in order to boost their portfolio returns, individuals should ensure they are not blinded by the hype.
“Zambia wanted to issue a government bond at 5.25%, but that is far too low for the risk. Countries try to get their share of the trend”, said Ledward.
Ledward also warns about companies who are issuing ‘mismatched’ debt in the wrong currency.
“A Zambian electricity company wanted to borrow in USD, but all its revenue and accounts were in the local currency. Such companies should not want to borrow in USD, but in the local currency”.
Of course, it’s not all doom, gloom and risk:
“I realise that sometimes I have spoken against my own asset class”, he admits. But for the long term, Ledward says he is feeling positive about emerging market debt. “Nevertheless, the returns are no longer what they once were. The 17% of 2012 will not return anytime soon.”
William Ledward will be speaking about emerging market debt at the Morningstar Investment Conference Europein Vienna in mid-March 2013.His presentation is titled “Emerging Market Debt: More than a Promising Asset Class”. To learn more about bond basics, click here.
