It is easy to identify reasons why the asset class has done so well over the past year. But there is still a case to be made for emerging market debt funds.
Perhaps the clearest reason for the strong performance over the past year is the improvement in what emerging debt fund managers call “credit fundamentals”. Basically the main emerging market debtor nations look in better shape than at any time in the recent past. “Last year the markets were recovering from a position of extreme weakness,” says J
eff Grills, an emerging market debt manager at JP Morgan Fleming.
For instance, Latin America was still recovering from crisis last summer. Argentina had defaulted on its debt back in 2001 and there was widespread concern about the prospect of a radical government being elected in Brazil.
In the event prospects for Latin America have improved significantly. Brazil’s government has turned out to be much more market-friendly than many had expected. Meanwhile, Argentina seems to be recovering from economic collapse.
Improved outlook
The outlook for other previous problem countries has also improved. Russia, which defaulted on its debt back in 1998, is doing well, particularly helped by the relatively strong oil price. Turkey, while still heavily indebted, also looks like it might be closer to resolving its difficulties.
The general economic environment for emerging markets has also improved. Many have benefited from rising commodity prices – since they are often exporters of raw materials – while current account deficits have tended to narrow. In addition, fund managers like the greater policy flexibility among the governments of developing countries.
Naturally there is always the possibility of difficulties suddenly becoming apparent in emerging markets. That is almost true by definition. But overall such markets are considered less risky than for a long time.
One key measure of this risk perception is what is known as the “spread” on emerging market debt. This is essentially the difference in yield between emerging debt and that available on American government debt. At present the spread, at about 500 basis points (5%), is at its lowest for about five years. A year ago it was 900 basis points on average.
Even when yields on American government debt rose sharply in July the emerging debt market held its nerve. Rather than panic the emerging debt market moved roughly in line with American treasuries. “It was a bloodbath but we survived,” says Raphael Kassin, an emerging market debt manager at ABN Amro.
Proposal dropped
But there are other reasons why emerging debt has done well over the past year. One is the dropping of a proposal by the International Monetary Fund to develop a new mechanism for restructuring sovereign debt.
Fund managers disliked the Sovereign Debt Restructuring Mechanism (SDRM) as they were concerned it would make it harder to recover their assets if a country defaulted. The idea was basically to create a system similar to Chapter 11 in America – where insolvent firms are given protection from their creditors – on a global level.
However, Collective Action Clauses (CACs), seen as more benign by fund managers, have been introduced instead. These allow debtors to change the terms of a bond – for instance by lengthening the maturity – without getting the agreement of all the creditors.
On the whole, fund managers seem happy or at least relaxed about this change. If it makes the restructuring process smoother then many see it as welcome. It will also take a while for such clauses to become common as they only apply to newly issued debt rather than existing bonds.
More generally emerging market debt has benefited from the economic and financial environment. Low interest rates and the difficulties facing other asset classes have benefited emerging market bonds. “Emerging debt remains competitive compared to other asset classes,” says Paul Murray-John, an emerging debt fund manager at Threadneedle.
Mainstream instruments
Low interest rates are important as they mean that it is generally difficult for investors to find yield. Good returns are not easily available on mainstream financial instruments. “It is a benign interest rate environment for us,” says Mr Kassin of ABN Amro.
In such circumstances it is clear that emerging market debt is likely to be seen as a good source of yield. As long as the risks of emerging markets are controlled they are likely to attract income-hungry investors.
In addition, returns on shares have generally been poor. Under such circumstances investors naturally look for growth potential in other asset classes such as fixed income.
Despite the strong gains over the past year there are some reasons for caution. Although there are no obvious country defaults ahead some risks can be identified.
For instance, if interest rates start to rise – as seems increasingly likely in the next year or two – it could hit fixed income in general and emerging market debt in particular. Since rising interest rates tend to coincide with stronger economic growth such a move could trigger a shift towards equities. In addition, inflation, which could also coincide with greater growth, is the enemy of all fixed income investment including emerging markets.
Repeat unlikely
Although it is hard to be certain about anything in the investment world there are two things that seem clear. First, the spectacular performance of the past year is unlikely to be repeated in the next 12 months. Recovery from a previous position of weakness was a key factor in the strong performance over the past year.
Second, spreads do not look set to be compressed still further. Investors are unlikely to come to view emerging markets as even less risky than they see them already.
Nevertheless there remains a case for investing in emerging market debt. It can provide an attractive yield while also supplying a diversifying element within a broader portfolio.
This article first appeared in the August 18th issue of Fund Strategy
