Strong fundamentals have helped market the asset class to a wider range of buyers, but not every investment is good value for pension funds. Luisa Porritt explains why
Ten years ago, emerging markets were considered to be a risky investment.
They were included only as a tiny proportion of portfolios to help boost prospects of higher returns. The idea exposure should be ‘capped’ came from the notion that, compared with developed markets, governments in emerging markets were less experienced in, and relatively incapable of, good financial management. The likelihood of default was assumed to be higher.
During the 1990s, investors lived through some stark examples of default: many were hit by Argentina’s crisis in 1994.
The 1997 Asian debt crisis had a negative impact on the entire asset class’s performance.
As the new millennium began, the memory of defaults remained relatively fresh. Since then, the perceptions of investment managers have shifted.
This revision of attitude is a result of how emerging market governments responded to the 2008 financial crisis. Emerging market debt suffered in the short term as some foreign investors pulled out.
But sound pre-crisis economic restructuring meant that emerging markets fared better than expected – there was no wave of government defaults as had been seen in the past. Since 2008, there have only been a handful of failures: in Ecuador, the Seychelles, Côte d’Ivoire and St Kitts and Nevis, and the effects of these were relatively isolated.
Emerging market assets showed they could behave like safe havens
The ability of many emerging market governments to be counter-cyclical and deploy fiscal stimulus measures was a wake-up call for investors, says Damien Buchet at AXA Investment Managers. “Emerging market assets showed they could behave like safe havens.”
Across the emerging markets spectrum, fundamentals have improved.
They hold an average “investment grade” rating, at BBB for corporates and BBB- for sovereigns. The JP Morgan EMBI Global Diversified Index, the main benchmark used by emerging market debt investors, includes 54 countries and has a growing membership.
Having learned from the Asian and Argentine crises, developing countries’ governments are beginning to enjoy the rewards of frugal behaviour.
Mexico’s 10-year dollar bond yields recently dropped to 2.5%, putting foreign investors’ belief in the Mexican government’s ability to meet its debt repayments on a par with the US, given that Treasuries of the same maturity hover around a similar yield level. A Mexican bond with a lifetime of 100 years meanwhile trades at around 4.8%, safer than a Spanish bond over a lifetime that is 10 times shorter, trading at 5.3%.
Smaller markets are capitalising on investor appetite for those elusive yields. Some developed market sovereign bonds have fallen out of favour, due to low interest rates keeping yields low, and even a changing view of solvency following Greece’s debt crisis, says Robert Stewart at J.P. Morgan Asset Management.
Existing AAA countries have a high debt to GDP ratio, so defaults have become a concern
“Existing AAA countries have a high debt to GDP ratio, so defaults have become a concern,” he added.
Proceeds from sell-offs in the developed world have opened the door for new entrants to the international debt market. Zambia’s debut bond issuance met with far higher demand than anticipated – ultimately it was oversubscribed 15 times. Mongolia’s $1.5bn of debt at five and 10-year maturities was oversubscribed 10 times, despite its own history of debt crises.
Nigeria became an ‘emerging market’ rather than a ‘frontier’ within the JP Morgan index, the second country to do so in Sub-Saharan Africa.
Not long ago, these countries would have found the private lending door shut and would have had to rely on support from such international institutions as the International Monetary Fund.
CHOOSING THE MARKET
Niche markets are not always suitable for pension funds. What funds gain in yield they lose in liquidity, and pension funds need longer-term security. They have to weigh up the benefits of extra yield to help meet their liabilities against the risk that ultimately they may get nothing back.
With such little upside, pension funds need to restrict the downside. And the smaller the market, the fewer investors accessing it. As large constituents, pension funds end up holding a sizeable share of the investment pool. When events turn sour, exiting becomes extremely difficult.
Smaller markets tend to fare less well in a downturn because of their less diverse economies: they often rely on a single commodity’s strength, and productivity is driven by only one or two large companies.
Some managers argue this is why external debt is more suitable for pension funds wanting to access emerging markets where there is low liquidity. There is no currency risk, as with local currency denominated-debt. Using hard currency (i.e. a widely accepted currency such as British sterling) means troubled debtors cannot issue a debt moratorium.
In the event of a crisis, obligations have to be met or new terms have to be agreed with creditors. There is no risk incurred from governments inflating away their debt, reducing the value of an investment. Hard currency is also free from withholding taxes. But others say value is lost through hard currency.
Last year, hard currency returns averaged 17%, but that number could fall in 2013, says Stuart Culverhouse at Exotix, an investment boutique that specialises in frontier markets.
Axa’s Buchet argues investment grade sovereign debt no longer holds any value, particularly that issued from Latin America. Countries such as Brazil, Columbia, Panama, Peru, Chile, and Paraguay have a relatively low default risk, but there is little yield to make their debt attractive, he says.
Brazilian 10-year bonds trade at just 50 basis points over US Treasuries, too small a spread to make entry worthwhile, Buchet adds. Opportunities to benefit from higher eastern European yields, in countries such as Lithuania, Romania, Croatia and Hungary have also been eradicated, he says. Several managers say downside risks have increased there, thanks to fiscal retrenchment elsewhere in Europe.
WEIGHING UP THE RISKS
Given the risks involved in either local or hard currency sovereign debt investment and the reward opportunity calculation that must be made against that, the requirement for trustee boards to know what they are investing in is all the higher within emerging markets.
For boards of trustees venturing into the asset class for the first time, it is best to do so in a phased approach, rather than diving in at the deep end, some managers say. Such managers advocate investing first in sovereign debt, then quasi-sovereign, then corporates.
As the investor grows more comfortable with the asset class, they may wish to move down the ratings scale – at which point rigorous analysis of fundamentals becomes key.
Corporate debt issuance is a growing part of the emerging markets universe. According to Luc D’Hooge at Dexia Asset Management, liquidity tends to be lower than for sovereign debt, but corporates are benefiting from an improvement in investor perception off the back of falling yields on sovereign debt.
Several managers think US corporates are not as attractively priced as their emerging market counterparties with similar ratings, where potential for further upgrades exists and investors receive a premium for taking on risk.
Emerging markets are also benefiting from an overall trend of investors moving away from equities and into fixed income. Most pension funds have a target to increase their overall fixed income assets to between 5-10% of their portfolios. Previously, that made up around 2-3%.
With more pension funds also raising their emerging markets allocation, emerging market debt can expect to play a larger role in pension fund portfolios in future.
Despite this shifting view of emerging markets, a number of investors are still slow to move.
In the institutional investment industry it’s risky for trustees to take a big step forward
Jan Dehn at Ashmore Investment Management blames this on an inability to recognise a changed world since the end of the Cold War. “In the institutional investment industry it’s risky for trustees to take a big step forward. They’re not rewarded much for success, and fired for failure,” he says.
Geopolitical changes over the past 20 years have driven the movement towards a ‘Washington Consensus’ on what should be done to reform struggling emerging countries’ economies. This consensus has boosted stability and growth across emerging markets, says Dehn. Average debt-to-gross domestic product in the emerging world is 25%, whereas in developed markets it is 250%.
But is it all too good to be true? Many managers say no, referring to the changed nature of the emerging market debt investor base as a reason the asset is more stable than in the past.
Hedge funds no longer have the same influence on the market, while proprietary trading desks at banks have diminished.
The real risk may be a bubble in fixed income, with US Treasuries leading the way for historically low yields across the asset class. High-yielding debt in particular is at risk of being mispriced.
But, says Jonathan Mann, head of emerging market debt at F&C Investment, expectations for returns are more realistic than they were during previous bubbles in technology and property, which offers some comfort.