Institutional investors are gradually getting the message on emerging market (EM) debt. JPMorgan put 2007 inflows into the asset class at just under $40bn, and expects that to be exceeded this year.
The story is compelling: the JPM GBI-EM Global Diversified Index returned 18.1 per cent last year – MSCI World was up 6.5 per cent and the Lehman Aggregate 7 per cent – and the risks that used to put investors off have diminished significantly.
“Most credits will continue to improve,” says Claudia Calich, portfolio manager of our top-placed fund at Invesco. “There may be a temporary pause for the next few months, but it’s very difficult to see any country wanting to re-leverage again.”
 | Jerome Booth, head of research at Ashmore Investment Management, says the increasing volume of pension fund, central bank and sovereign wealth fund allocation has been a stabilising influence. “Right now, emerging debt is safer than Treasuries, and less volatile. In fact, local currency debt indices have been less volatile, on a monthly basis, than US Treasuries since late 1998,” he says. |
Mr Booth concedes it is unfair to compare indices that reference dozens of business cycles with another that references just one. But that is the point: in asset-allocation terms, EM debt offers diversification within itself as well as away from traditional markets.
“Decoupling is not a term I like,” Mr Booth says. “Nobody can escape a US slowdown, but the pain of it is spread so widely, I’m of the view that emerging markets will grow about 7.5 per cent next year, and could contribute 80 per cent of global growth.”
Diversification
There is a still a lot of potential for diversification: while 70–80 per cent of EM debt is local currency, only 10 per cent of foreign investment ventures there. Indeed, the International Bank for Reconstruction and Development is launching a $5bn fund to plug part of the gap, up to 30 per cent of which could go into corporate bonds.
This reflects trends in the strategies of our top-performing funds. “Recent years have seen a marked increase in the use of both local currency EM debt and EM corporate credit,” observes Morningstar fund analyst Lawrence Jones. “The chief reason for this is the fact that developing country debt markets have themselves been shifting in this direction. As many developing nations have seen improved fiscal balance sheets they have retired hard currency debt and increasingly issued local currency bonds. Moreover, corporate-issued debt in EM countries rose from roughly one third of total issuance in 2001 to nearly 70 per cent in 2006. With the dollar falling significantly in 2007, funds that held a greater percentage of US dollar-denominated bonds lagged those that ventured deeper into local currency issues.”
Ms Calich describes the Invesco fund’s focus as diversifying alpha sources beyond country and duration positioning to include currency positioning and security selection.
“We make people aware that we follow the JPM EMBI Global benchmark but over the past couple of years the best opportunities mean that we’ve had about 60 per cent of that index, lessening the volatility and loosening correlations in some of our positions.”
As for the other 40 per cent, countries can be excluded or overweighted up to three times, and 10 per cent can go to non-benchmark countries (the fund currently has Angola, Guatemala and Jordan); 30 per cent can go to corporates; and up to 35 per cent to local currency debt, recently relaxed from 30 per cent. From its tracking error of 2-5 per cent the fund targets 3 per cent alpha, and performance attribution shows that 45 basis points (bp) of that comes from corporate credit risk and 120bp from local currency and interest rate exposures.
Bespoke deals
In corporate credit, Ashmore has been focusing on super-safe bespoke deals because “the conventional corporate bond market has not been that attractive”. The ABN Amro fund currently has less than 1 per cent in corporates.
In stark contrast, although Ms Calich has been diversifying her exposure, as the high-yield market remains nervous of the prospect of a US slowdown, she currently has 30 per cent in corporates and says that, thanks to post-subprime volatility, this is her best source of credit alpha at the moment. The focus is on Russia’s oil and domestic sectors and on Mexico, where holdings include a telecoms company, a bank and a homebuilder that has been punished over-severely because of subprime fears. Both country positions are therefore risk overweights despite being slight country underweights.
Only 40 basis points of the Invesco fund’s alpha comes from duration management – probably the biggest factor for global bond mandates. As duration management has become more important in dollar-denominated debt – as more EM countries achieve investment grade and spreads over US Treasuries have reached historical tights – the introduction of local currency has balanced it out again. Furthermore, initiatives such as the Brady Plan have concentrated EM debt liquidity in longer-dated securities, the exact opposite to developed markets.
“There is one duration number,” observes Tomasz Stadnik, co-head of emerging market debt at ABN Amro Asset Management, whose Global Emerging Markets Bond Fund can go up to 50 per cent local currency. “But how relevant is it when half of this duration is non-dollar?” The fund is concentrated in long-dated securities, with nothing at the mid-point but around 20 per cent in short-dated bonds, and Mr Stadnik confirms that that is both a duration and a convexity call.
For Ms Calich, diversity is the key when it comes to curve positioning, so shorter-dated corporates sit alongside long-dated sovereigns. Mr Booth is similarly focused on alpha diversification rather than curve positioning.
“In G7 markets, short maturity is often equated with less risk,” he says. “In emerging markets all that goes out the window. Forget it. From a risk management perspective, it’s the liquidity that really matters, whatever the maturity of the bond. If you get a negative event, liquidity can concentrate on one or two bonds – and can even go up – while drying up absolutely everywhere else.”
His portfolio’s sensitivity to US rates varies, he says, and while it can be relevant over short-term periods, over the long term correlation is almost zero (the current US loosening regime has coincided with a big EM debt rally, for example).
“The first thing to understand is that emerging debt – with exceptions such as Argentina, Venezuela and Ecuador – is not a credit market. So in our weekly scenario planning meeting to work out what the main risks to the portfolio are, these might include US interest rates – but it could just as easily be the oil price, an foreign exchange (FX) market or a geopolitical event. Therefore, when we are thinking about where we are on the curve, it’s a function of sensitivity to all those things together. A lot of people out there who are not emerging market specialists have this enormous concentration on managing duration, and they miss out.”
Despite the difficulty of calling the dollar, the importance of local currency exposure is certainly a consensus among our top three.
“Local currency has been a key component of the strategy since I joined in 2004,” says Ms Calich. “We’re now at 30 per cent and we expect to remain fully invested in the short to medium term, especially given dollar weakness prompted by fears of a US slowdown. But eventually the dollar has to start turning; we are already a couple of standard deviations away from historical averages. I’d anticipate going back to maybe 15 per cent, but will we ever go to zero? Probably not. The beauty of local markets is that there’s always going to be some central bank easing while others are tightening. Even in August, when the whole subprime world was blowing up, Nigeria and Iraq were appreciating.”
Ashmore’s Emerging Markets Liquid Investment portfolio has the most diverse opportunity set of our top three. There is a single-country limit of 25 per cent and a limit of 10 per cent on single issuers; 25 per cent can be allocated to local currency; the fund can invest in corporates; but most notable is the fund’s “barbell” approach to liquidity, which sees 70 per cent going into the most liquid securities to open up space for less liquid special situations (chiefly opportunistic distressed debt), which currently account f
or 20 per cent of the portfolio.
Liquid debt
The fact that local currency debt is currently more liquid than dollar-denominated debt (enhanced by the fund’s use of fully funded currency forwards to replicate local currency bonds) obviously plays into this overall strategy. “Local currencies could appreciate something like 20 per cent against G7 currencies over the coming years,” says Mr Booth, “but we can also add a lot of alpha as we enter a period of much greater FX volatility and turbulence in the G7.”
The ABN Amro fund has 50 per cent available for local currency debt, but it was not always thus. This fund went through huge changes last year following the departure of portfolio manager Raphael Kassin to Credit Suisse Asset Management in April and his replacement by Chris Kelly and Mr Stadnik – who joined as co-heads of emerging market debt from Credit Suisse Asset Management.
“At Credit Suisse we managed a fund that was similar in investment objectives – a total-return fund as opposed to benchmark-oriented,” says Mr Stadnik. “However, our background combines more than just hard-currency sovereign debt. Introducing the 50 per cent limit for local currency was the key change we made: not taking advantage of the diversity of local markets would be sub-optimal for our investors.”
They currently use half of that leeway, but not because they are concerned about a dollar rally. “That has to do more with the G10 currencies,” says Mr Stadnik. “Against EM currencies we are a bit more sanguine, and still see some as fundamentally undervalued.”
He agrees with Mr Booth that relative productivity gains provide significant theoretical support for long-term EM currencies, but he sets more store by those policymakers who are unwilling or unable to use interest rate hikes to control creeping inflation, and resort to letting currencies strengthen instead. “Look at Russia and China,” he says. “Many people see China as a great currency trade, but we regard the ruble as a nice substitute: willingness to let the ruble appreciate as an inflation cure is much more pronounced in Moscow than in Beijing.”
Overweight argentina
Moving on to the subject of country positioning, perhaps the most remarkable thing is that the only significant overweight shared by all our top-three funds is Argentina (Invesco has benchmark +5.1 per cent, Ashmore +3.5 per cent and ABN an astonishing +23 per cent). It was among last year’s worst performers – although that could easily provide the rationale for an overweight: if we take the only “real” credits in EM debt, we find 2007’s two worst performers (Argentina and Venezuela) but also Ecuador, which finished up 44 per cent as the market came to terms with the recently elected president Rafael Correa.
“Brazil is our largest Latin American exposure,” says Mr Booth, “but there’s more risk and dynamic in Argentina and Venezuela.”
These are two big positions in by far the most concentrated portfolio in our top-three: the ABN fund has just 14 country exposures, whereas the Invesco fund has around 30 and Ashmore around 40. The fund has a tracking error averaging 10 per cent: as Messrs Kelly and Stadnik have it, why hug a (dollar-denominated) benchmark that represents less and less of the real universe?
But despite positioning well over three years, the ABN fund languished at the bottom of league tables for 2007, losing 5.9 per cent – largely because of the way its huge Venezuelan exposure was caught up with the departure of Mr Kassin. “On Argentina and Venezuela we have clearly different views from Raphael,” says Mr Stadnik.
Like most other investors, Messrs Kelly and Stadnik have scaled down Venezuela because it has been such a tricky call. Oil prices have fuelled growth, but the regime of president Hugo Chávez has not used this to put its fiscal house in order – $800m of 30-year dollar debt was issued in the third quarter of 2007; and markets took a dim view of Mr Chávez’s attempt to abolish presidential term limits. But there is also little doubt that the $4 billion that left the ABN strategy after Mr Kassin’s departure led to technical (and enforced) selling that did not help matters.
Elsewhere in South America, another notable ABN bet is an 8 per cent underweight to Brazil. A widely held overweight, Ashmore holds benchmark +7.4 per cent. “Basically, Brazil is a low-inflation economy that hasn’t realised it yet,” says Mr Booth. “Interest rates are ridiculously high, so on the currency we are in a virtuous circle as rates come down and the fiscal accounts improve. It’s a core position.”
Mr Stadnik agrees that real rates are high but with one eye on inflation, he does not expect nominal rates to come down further this year: “As long as there is no overheating or serious crash in the equity market, there is potential for both the real and for Brazilian rates.”
There are also differences over Russia. Messrs Kelly and Stadnik are 8 per cent underweight (although Mr Kassin had no exposure at all); Ms Calich is underweight because sovereign spreads are so tight, but slightly overweight credit risk to buy the positive macro story; whereas Russia is Ashmore’s biggest position at 17 per cent, 8 per cent overweight.
“Russia is a lower default risk than many countries in Western Europe,” Mr Booth observes. “It has $500bn in reserves and natural upward pressure on its exchange rate through Dutch disease, inflation will mean appreciation of the currency and they have huge capital flows.”
Ashmore’s significant overweights in Poland and Hungary perhaps represent similar local currency, inflation-related plays.
There is consensus among our top three on Turkey, although it represents the most serious bet for the ABN fund: from zero under Mr Kassin, Messrs Kelly and Stadnik have made it their second-largest exposure at 15.4 per cent. (Ashmore and Invesco are bullish, but close to benchmark). They are hoping for a repeat of last year’s performance: Turkish bonds were up nearly 50 per cent despite volatile exchange rates, a current account deficit, a headline-grabbing election controversy and skirmishes with Iraq-based PKK rebels. “Turkey is a great story precisely because of all that,” says Mr Stadnik. “If everybody was saying Turkey had no problems, there wouldn’t be any money to be made.”
They like the new government’s economic team, and have confidence in the deficit’s sustainability, given the pace of privatisation and foreign investment. As Mr Kelly points out, factoring out the balance of the oil trade reduces the current account deficit considerably, which is significant given the prospects for oil price stabilisation this year.
Philippines focus
Another big move for the post-Kassin ABN portfolio has been to halve Asian exposures to 18 per cent, focusing on the Philippines and Indonesia. This brings the fund closer to the consensus among our top three that the Philippines represents one of the few high-yielders in markets where spreads would struggle to tighten and that, along with Indonesia, it offers the region’s strongest currency and rate-cutting dynamics. Indonesia still represents a significant overweight, however, despite cutbacks on concerns about issuances such as the recent $2bn in Eurobonds.
Outside the major markets, Africa is increasingly prominent in the Invesco and Ashmore portfolios. Both have considerable exposures to non-benchmark Nigeria, for example; Invesco also has Angola and is overweight Egypt. “You have massive improvement in debt ratios for certain countries,” Ms Calich observes. “FX reserves in Angola, an oil exporter, are soaring. There is liquidity risk, and clearly a lot of political risk, but as long as you get the bottom-up policy right they can provide good performance and diversification.”
This is one area where Ashmore, with its $33bn in emerging markets, feels it has its sharpest edge and one of its most important roles. “We’re the largest – it’s as simple as that,” says Mr Booth. “And as a large investor we’re talking to central banks, finance ministers and institutional investors every week in some countries. We only do emerging markets, so our partners can see we are totally committed. One of the problems with getting a good local bond market going in places like Africa is having first-world custodians interested. We have over $20bn with our main custodian, so if we ask them to resource that sort of thing they’ll do it for us.”
The firm is also a major agent in shepherding several African countries through their first sovereign bond issuance.
But as Mr Booth observes, emerging markets is not all about exotic pioneering – it is the core, the majority of global economic growth. He recommends pension funds start thinking about allocating 35 per cent of their strategic portfolios to emerging market asset classes, while leaving the tactical allocations to specialised funds such as our top three, to open up those all-important, diverse sources of alpha.
“Five years ago when we went to a big pension fund with a strategy like EMLIP, the fact that we’d got local currency or special situations in there would sometimes lose us mandates, or we’d have to do separate accounts purely in sovereign dollar debt,” he says. “Over time many clients with those accounts looked at EMLIP, saw it doing better, and migrated. Now those things are universally appreciated as adding a lot of value to the portfolio.”
