To a number of seasoned observers of emerging markets, it remains something of a mystery that investors remain famously underweight emerging market debt and equity, given the influence these markets now have in the global economy. After all, the BRICS alone now account for more than 25% of the worlds GDP and for about 18% of total global market capitalisation, up from 18% and less than 4% respectively in 2000.
As champions of the emerging market debt asset class never tire of arguing, it is not just the global weight of emerging markets GDP that makes investors underweight position illogical. So too do the returns they have offered. With the benefit of hindsight, those returns have been especially seductive in many of the worlds least developed (or so-called frontier) markets, and in some of the special situations arising from crisis. Those are the sorts of opportunities that investors are prepared to pay specialist boutiques such as Exotix to unearth. Established in 1999, Exotix specialises in illiquid bonds, loans and equities, which means that it is comfortable looking at everything from Bosnian bonds to Kenyan brewing stocks as long as they are capable of generating alpha.
Today, Bosnian debt is one of Exotixs favoured markets, as are bonds from the Seychelles. "Both are yielding over 10%, which seems to be a magic number," says Gabriel Sterne, associate director and economist at the firm. Exotixs other favoured picks include Argentine warrants, Congolese bonds and an octet of countries that have lagged the recent rally, including Albania, Angola, Costa Rica and Montenegro.
You dont necessarily need to have dabbled in markets like Bosnia or Congo to have generated some alluring returns from emerging market debt. Between January 2003 and December 2010, emerging market debt as measured by the JP Morgan EM indices posted an annual average return of 14.44% in local currency, which is bettered only by oil (27.97%), emerging market equities (25.82%), and 11.22% in dollars, just behind European equities (12.67%), gold (12.85%) and wheat (12.59%).
Analysts point out that at a sovereign and corporate level, the strength of this performance is a by-product of robust credit fundamentals. In a recent analysis of the emerging market corporate debt asset class, Ashmore Investment Managements head of research, Jerome Booth, notes that emerging market corporates proved their worth during the crisis of 2008-09 and that default rates are projected at below 1% in 2011. According to the same research, in six of the last eight years these default rates averaged 2.49% versus 3.42% in the US.
Another important feature of emerging market debt as an asset class is its low correlation with other mainstream assets, together with the modest correlation levels from one country to the next. Despite concerns about the recent uprisings in the Middle East and whether or not the unrest will spread further, analysts also insist that political correlation and therefore the danger of geopolitical contagion in the emerging market universe is also low.
At Exotix, Sterne says this is especially applicable to frontier markets. "What is probably not appreciated enough is that frontiers are ideal for diversification strategies as political risk in, say, Ivory Coast is completely uncorrelated with what may be happening in Belarus or Venezuela," he says. "In this respect, recent events in the Middle East have been atypical."
Safer than the West
Equally important, say analysts, is that although their economic fortunes are inevitably intertwined with those of developed markets, it is inappropriate for investors to assume that emerging market assets should move in lockstep with developed economies. "Are the emerging markets of central and eastern Europe going to decouple?" asks Booth, rhetorically. "Absolutely not. But that is the wrong question. The appropriate question is, are they safer than western Europe? The answer is yes, because they have the policy tools to cope with economic shocks."
Issuers in the CEEMEA region will be heartened that much of this message appears to be getting through to investors, although many of the borrowers that have seen the strongest demand from international mainstream investors will no longer consider themselves to belong in the emerging market category. "There is a recognition among investors that CEEMEA sovereigns have very different dynamics and quanta of debt to some of the borrowers in western Europe," says Jonathan Brown, head of emerging market syndicate at Barclays Capital in London.
Others agree, saying that like it or not, investors in European government bonds are being forced to alter their analytical approach to the market. "The sovereign debt crisis in Europe is forcing rates investors to become credit investors," says Martin Wiwen-Nilsson, head of the growth market financing group for EMEA at Goldman Sachs. "If youre investing in most western European sovereigns today, credit analysis based on fundamentals is becoming just as important as it is in the market for EM sovereigns."
As pricing levels between the two regions converge, this relative value analysis will become increasingly important. For the time being, however, growing demand for exposure to the CEEMEA region has been especially striking among US investors over the last 12 months. US accounts, for example, took up 64% of Lithuanias $750m 2021 transaction, led by BNP Paribas and JP Morgan in March, which was the Baltic sovereigns longest ever dollar bond.
The same month, US support was equally conspicuous for Croatia, which placed 58% of its $1.5bn issue with US institutions. Barclays Capital, Deutsche and JP Morgan led the 10 year Croatian benchmark, which was covered roughly four times.
In terms of US placement, both these transactions were trumped, however, by Ukraines $1.5bn 10 year deal in February, via JP Morgan, Morgan Stanley and VTB. This generated demand of $3.5bn, with 77% of the bonds sold in the US.
Bankers say they expect demand for CEEMEA sovereigns in dollars to continue to dwarf demand in euros. "The depth and pricing of the dollar market has been much better in dollars than in euros," says Brown at Barclays Capital. "The development of the euro market for emerging market sovereigns has not lived up to expectations. Demand used to be driven by investors such as the German Landesbanks, but has not recovered since the crisis."
Another pocket of demand in which demand for CEEMEA exposure has been notable in recent months has been in the sterling market, which bankers say is significant given the dominance in this market of pension funds and insurance companies. This year, one of the most striking examples of this phenomenon was the £350m 20 year issue from Russian Railways in March, which was led by Barclays Capital, Goldman Sachs and VTB Capital, and was the first sterling bond from a Russian borrower since 2007.
One of the stated objectives of Marchs issue from the Baa1/BBB/BBB rated Russian borrower was the diversification of its investor base to one with a more traditional investment grade profile, and the response to the transaction suggests that this particular mission was accomplished. An oversubscribed book allowed the borrower to increase the size of the issue from £250m to £350m, with 43% of the bonds placed in the UK and just over a third taken by insurance companies and pension funds.
The same month, Abu Dhabis International Petroleum Investment Company (IPIC) also tapped successfully into UK institutions demand for longer dated credit, placing a £550m 15 year tranche alongside five and 10 year tranches of Eu1.25bn each. BNP Paribas, Crédit Agricole CIB, Deutsche, Goldman Sachs, Santander and UniCredit led the three-tranche IPIC deal, with 68% of the 2026 sterling tranche placed in the UK, and 70% sold to fund managers.
Others agree that the increase in demand from real money investment grade accounts has been one of the most discernible trends within the CEEMEA investor base in the last year or so. "There has definitely been some reweighting of asset allocation towards emerging market bonds by US real money accounts, especially insurance companies and pension funds," says Peter Charles, head of CEEMEA debt syndicate at Citi in London.
"Weve seen that on two levels. First, there has been rising demand for hard currency bonds from issuers like Hungary and Lithuania. Second, a huge amount of institutional and mutual fund money has been flowing into local currency product in emerging markets, which is adding to the range of funding options for sovereign debt management teams and also for banks and corporates in CEEMEA."
One of the clearest examples of this demand, says Charles, was the Hrv2.385bn ($300m) issue led by Citi and Credit Suisse for Ukraines Ukreximbank in February, which was the first hryvnia denominated issue that can be settled through euroclear.
More than 90% of the Ukreximbank bond was placed with real money institutional investors, and there are at least two compelling reasons why more local currency denominated issuance can be expected to emerge from CEEMEA markets over the coming months.
The first of these is that in vivid contrast to Latin America and Asia, local currency debt markets have been slow to take shape in many CEEMEA markets. "In Asia the balance of local versus international currency issuance is roughly five to one," says Fergus Edwards, global head of emerging market syndicate at UBS in London. "In CEEMEA it is probably the other way round. Last year about 80% of bond issuance from CEEMEA by volume was in international currency, so there is clearly scope for local currency markets to expand."
Others agree, although as Gunter Deuber, head of CEE Research at Raiffeisen in Vienna, points out, local currency markets are already well developed in a number of CEEMEA economies. "Local currency markets definitely have room to grow gradually, but we shouldnt underestimate the state of their development in the core CEE countries, especially Hungary, Poland and the Czech Republic," he says. "In Hungary the local government bond market accounts for close to 50% of GDP, while in Poland it is about 40% and in the Czech Republic it is just over 20%. The smaller countries obviously have some room for improvement, and are also more dependent on international issuance."
A second reason why there is plenty of scope for more local currency debt issuance in CEEMEA is the increasingly strong investment case that the asset class is presenting to investors, given the potential for alpha generation on the currency side as well as through spread compression. An analysis published by Investec, which scrutinised the returns on a number of asset classes between 1993 and 2009, provides compelling evidence. "While local emerging market debt delivered slightly higher [annual] returns (10.9%) than hard currency emerging market debt (10.4%) over the period reviewed, these returns were produced with significantly lower volatility (9.4% compared to 13.7%). Therefore exposure to emerging market currencies actually reduced overall levels of portfolio risk."
Another important source of new demand for CEEMEA debt has been the local investor base. "The big change weve seen in recent years has been the more significant participation by investors within the CEEMEA region itself, which in the past had been fairly minimal," says Charles at Citi.
A small proportion of that demand has come from pension funds, which have started to take shape in the CEEMEA region, most notably in Poland. The bulk of local demand, however, is coming from banks, most notably in Russia. There, according to a report published by Moodys in February, banks have more than doubled their investments in domestic bonds over the last two years, to around $150bn, while loans grew by only 8% over the same period. "Although lending should accelerate in 2011 as the economy recovers, the bond market is likely to outperform the loan market in terms of growth," notes Moodys.
Flourishing demand for corporate bonds from Russian banks is in part a legacy of the crisis, says Gleb Shpilevoy, credit research analyst at Raiffeisen in Vienna. "The Russian corporate bond market was growing before the crisis, but the turmoil gave the market a boost in terms of its structural development, with volumes up 150% since the Lehman collapse," he says. "The stimulus package restored the health of the corporate sector quite quickly and meant that the banks did not have many problems in terms of asset quality compared to their neighbours in Kazakhstan and Ukraine. They chose to invest their liquidity in bonds which they prefer to loans from a structural perspective, even if these bonds are illiquid issues that arent placed in the market. So in 2009 and 2010 we saw banks structuring loans as bonds that were repo-eligible with the central bank and keeping them on their balance sheets."The strength of Russian bank demand, thinks Moodys, is likely to attract more issuers across a broader spectrum of credit quality. The agency advises that it sees "a growing number of weaker tier three companies issuing domestic bonds, as access to bank loans remains challenging. This could increase the level of risk in banks securities books, particularly as banks start looking for higher yield."